The Federal Reserve on Wednesday took another step in the long road to policy normalization in the post-pandemic economy. At the monthly meeting of the Federal Open Market Committee, the central bank kept its policy rate unchanged in a range between 0 and 25 basis points.
But it is clear that given the accelerating economy, a forecast of higher inflation through 2023 in the FOMC’s Summary of Economic Projections, along with changes to the “dot plot”—which now implies two rate hikes by late 2023—that we have entered the beginning of the end to the Fed’s emergency programs to address the pandemic.
In some respects, the Fed has been signaling this for some time. It is clear that the Fed is setting up for a more formal discussion of reducing its accommodative policies later this summer, to be followed by a probable change in the policy statement in September. That shift will provide forward guidance on changes to its $120 billion in monthly asset purchases starting early next year.
The major changes in the Summary of Economic Projections indicate that the Fed expects to begin raising rates a few months earlier than expected—most likely in late 2023. The dot plot, which is a compilation of committee members’ projections for the federal funds rate, implies at least two rate hikes by then, and 13 of the 18 forecasts expect at least one rate hike in 2023, up from seven in March. One noticeable change is that there are seven participants now expecting a rate hike next year, up from four in March.
Summary of Economic Projections
The inflation forecast has adapted to the reality of the data and now implies that inflation will be 3.4% on average this year, 2.1% in 2022 and 2.2% in 2023. The long-run forecast remains at 2% and the long-run federal funds rate is unchanged at 2.5%.
The Fed expects a decline in the unemployment rate to 4.5% this year, which is unchanged from March, followed by a drop to 3.8% next year and to 3.55% in 2023. This implies that the Fed expects the economy to move back into full employment sometime between late next year and 2023, if one believes that the non-inflation accelerating rate of unemployment is near or below 4%.
The FOMC’s statement on Wednesday altered the language in some interesting ways. First, it now states that the progress on vaccinations has reduced the spread of COVID-19, in contrast with the April statement that noted the pandemic is causing tremendous human and economic hardship, which is no doubt one reason for the Fed’s more optimistic growth forecast this year.
Second, and most important, the Fed now says that with inflation having run persistently below the longer-run goal of 2%, there is still room for inflation to moderately exceed that rate and for the Fed to achieve its longer-run goal. The shift implies that the Fed is laying the groundwork for the eventual change in its accommodation, but not until inflation stays moderately above 2% for some time.
Third, there was no change in the language around its asset purchase program. The Fed was careful not to alter the forward guidance around that by keeping the phrase “until substantial further progress has been made towards the committee’s maximum employment and price stability.” In fact, Chairman Jerome Powell led off his press conference by reiterating the dual mandate and the Fed’s intent to maintain its policy stance until its goals are met.
Powell and the committee hewed to its language on substantial progress and noted that at an unspecified time it will be appropriate to formally comment on the eventual unwinding of the Fed’s asset purchases, known as tapering.
We expect that when the FOMC minutes are released in a few weeks, the Fed will have meaningfully started talking about tapering. And Powell made sure to maintain the current outcome-based policy stance by noting that the data will determine the outlook for tapering. While tapering is not tantamount to tightening, one should expect market participants and investors to begin to price this in.
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