The Federal Open Market Committee on Wednesday said it had retained its accommodative policy stance by keeping the federal funds rate in a range between 1.5% and 1.75%. Based on recent strong labor market reports, the Fed revised its unemployment forecast from 3.7% to 3.6% for 2019 and from 3.7% to 3.5% in 2020 in its December summary of economic projections.
The FOMC did not alter its long-term growth forecast of a rate of expansion between 1.8% and 2%. The long-run unemployment rate forecast of 4% implied by the summary strongly suggests that the Fed is willing to tolerate a lower rate of unemployment and is characteristic of the dovishness that has become the norm inside the FOMC. This reinforces our view that with the 2020 elections approaching, the Fed will keep interest rates on hold.
The most significant change coming out of the two-day FOMC meeting, in our view, was the movement in the dot plot into alignment with the current policy rate, with the 2020 to the midpoint of the current target range near 1.6%. The 2021 and 2022 targets moved to 2.1%. To put this in perspective, the current effective policy rate trades near 1.55% on a daily basis.
Using a modified Taylor rule, that implies that the Fed’s estimate of the real neutral rate is somewhere near .25% and the non-accelerating inflation rate of unemployment is 3.5%. This gives a sense about how accommodative monetary policymakers believe they have to be because of structural changes in the domestic economy and given the fact that the FOMC revised down its core inflation estimate from 1.8% to 1.6% for 2019. It expects a 1.9% core inflation rate in 2020 and 2% in 2020.
In short, the Fed thinks it can err on the side of caution and has room to maneuver should the trade war intensify or if there is an exogenous shock to the economy.
This strongly implies that there would need to be a robust reacceleration in the path of domestic and global growth, in addition to a significant rolling back of the trade conflict between Washington and Beijing, for the Fed to consider hiking rates.
Moreover, the Fed is likely to introduce a new inflation target in early 2020 that will be a more aggressive form of forward guidance involving an averaging of the core inflation target over time and the introduction of a standing repo facility to ease strains in the overnight market.
This suggests that next year is setting up as favorable to risk assets even as the economy produces growth at or below the long term rate of 1.8%. We think that the Fed will want to avoid changing the policy rate while introducing major changes to the policy framework and seeking to stabilize the stress evident in the repo market.
There were no dissents to the policy rate decision, which suggests a public pause in the internal disagreements until the minutes for this FOMC meeting are released in January 2020.
