The Federal Open Market Committee on Wednesday kept its policy rate in a range between 3.5% and 3.75% while revising higher its forecast for growth. At the same time, the FOMC kept its forecast for the unemployment rate this year at 4.4% and revised its forecast for inflation higher, to 2.7%.
The FOMC’s policy rate forecast continues to indicate a probability of one 25 basis-point rate cut this year, which we think will most likely be pushed back to later in the year, and another reduction next year.
The clear takeaway from the FOMC’s statement and Summary of Economic Projections is that the evolving oil shock has raised uncertainty in the economy, which will result in a period of risk management by the central bank.
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An energy shock like the one that is taking place is a central banker’s nightmare as it creates tension between a shaky labor market and rising inflation.
One can observe the vast difference of evaluations on the impact of the war on the economy inside the Summary of Economic Projections. The increase in the inflation forecast amid the 2.4% growth pace points to a greater risk of stagflation.
We are somewhat skeptical that the economy will just charge right through this heightened period of risk while inflation advances to 2.7% and gross domestic product grows at a 2.4% pace, which is up from the 2.3% rate that the Fed forecast previously.
That scenario seems optimistic. If it is true, it suggests that the economy is on a much stronger footing and that rate cuts should not be in the cards this year.
Hopium is not a strategy. One gets the sense that the Fed’s current economic projections are dead on arrival and that central bankers, like the rest of us, are in a wait-and-see mode on how long the war lasts and what residual long term damage it does to oil production.
A simultaneous increase in prices, rising unemployment and what we expect to be a decline in aggregate demand create a toxic supply-side mix that central bankers are ill equipped to address. That is why the Summary of Economic Projections put forward on Wednesday does not add up.
The Fed’s traditional playbook is that when there is tension within its dual mandate of stable prices and maximum sustainable employment, it leans toward containing inflation. Stable prices, after all, are a precondition of full employment. The committee today simply is not well aligned on what to do in the near term.
For this reason, uncertainty and risk management are the primary takeaways from today’s policy decision.
The dot plot and SEP
The revised dot plot, which is the FOMC members’ interest rate forecast, strongly implies one rate cut this year and one next year. There were three participants who reduced their rate cut forecasts from three to one this year.
We think the probability of a rate cut has declined and that if there is one it will be later in the year, most likely at the September or December meeting.
For each day the war continues, the probability of a rate cut dissipates.
The SEP, to be polite, reflects a broad divergence of evaluations across the FOMC. Most notable is the increase in the inflation estimate to 2.7% in both the top-line and core personal consumption expenditures index, while the estimate for next year was lifted to 2.2% for both.
Inflation has been well above the Fed’s 2% target for the past five years and we expect the PCE and the consumer price index to move to a range between 3.5% and 4% in the March and April inflation reporting period.
The unemployment rate estimate remained unchanged at 4.4%, which is below our expectations of a move to 4.6% this year.
Just as important, the Fed lifted its estimate of the long-run terminal federal funds rate to 3.1%, which is well below our estimate of 3.5%.
Policy statement
The major change to the policy statement was the inclusion of the phrase “the implications of developments in the Middle East for the U.S. economy are uncertain.” One gets the sense from the statement, SEP and the press conference that the Fed continues to be attentive to risks to both sides of its mandate.
There was one dissent, as expected, by Governor Stephen Miran.
Press conference
Fed Chair Jerome Powell, in his remarks after the meeting, noted the difficulties around creating a forecast, which will be interpreted as this SEP being a disposable document.
At the same time, Powell signaled that price stability remains a pre-condition for maximum sustainable employment, which is why the focus on risk to both sides of the mandate was an important part of the press conference.
As for Powell’s term as chair, which ends in May, he said that he intends to remain on the Fed until the investigation into his Congressional testimony is complete. He added that he would be willing to remain if the nomination of Kevin Warsh, Powell’s replacement, remains stuck in committee in the Senate.
The takeaway
While the Fed will look through a temporary increase in inflation because of the war, it will focus intently on inflation expectations and any hint of an increase in core inflation, which excludes food and energy. We do not expect a rate hike in the near term or this year, but we cannot discount it given the rising risk to the outlook.
The Fed must be patient as it assesses the impact of the war beyond the obvious. But all parties should be careful not to discount short-term public inflation expectations that were part of the policy error in 2021-22.
The Fed must plan for all contingencies, including possible rate hikes should pricing expectations move sharply higher and core inflation increase.
Until the war ends, risk management will be the analytical framework in which monetary policy should be understood.
