The Federal Reserve on Wednesday set the stage for multiple increases in the federal funds policy rate next year by accelerating the tapering of asset purchases to $30 billion per month, up from $15 billion. The tapering should be wrapped up by March.
The accelerated tapering provides increased flexibility for the central bank to hike rates as early as March.
This provides increased flexibility for the central bank to hike rates as early as March, which will be the next time the Fed updates its Summary of Economic Projections. While we think the rate hikes will be in June, September and December next year, the March policy meeting is now in play.
With the forecast on the core inflation policy variable now expected to be above the Fed’s 2% inflation target through 2024, the Fed will be moving aggressively to dampen higher inflation expectations.
Some in the market will interpret that as increasing the probability of a policy error on the part of the central bank in 2023 and 2024. In our estimation, that is premature and erroneous. The real economy is booming and can absorb a gradual and orderly pace of policy normalization.
The recent surge in inflation will require higher rates, and the Fed clearly thinks that its work will not be done in the near term and will require sustained attention over the next three years.
Five central bankers think that the policy rate will soar above the 2.5% long-run rate in 2024 and only two think that the current business cycle will result in a move higher in the terminal rate to 3%.
Based on the Summary of Economic Projections published on Wednesday after the Federal Open Market Committee meeting, it appears that the Fed is planning to hike rates at least three times next year with the possibility of more should inflation prove stickier than the central bank is forecasting.
The FOMC’s projections of interest rates, known as the dot plot, imply that a majority of central bankers at the Fed now expect three hikes in 2022, 2023 and 2024. That should create a series of expectations among market participants and other policymakers of a gradual and orderly pace of policy normalization through the end of 2024.
As with all monetary policy, the sequencing of how the Fed shifts toward a tightening bias remains the key to understanding the evolution of policy.
We now expect the Fed to wrap up its asset purchases by March, then wait until June to kick off its rate hike campaign, which we expect will increase on a quarterly basis until the end of 2024.
It is hard to believe that the Fed will not in upcoming meetings update its forward guidance around balance sheet policy and the runoff of the proceeds of maturing assets. For this reason, the discussion about the pace and timing of rate hikes that may occur simultaneously with a runoff of the balance sheet will move to the forefront of the Fed’s policy discussion.
But the policy path is not going to be on a stairway to heaven with respect to the policy rate moving above the long-term 2.5% terminal rate.
It is more probable that the Fed will hike rates until the difference between inflation and the policy rate equals the long-run real equilibrium policy rate—better known as R*—that we think is 0.5%. That would imply that firms and investors should anticipate a series of rate hikes through the end of 2024.
The Fed’s estimate of the terminal or long-run policy rate remained 2.5% while its estimate of full employment stayed at 4%. While we agree with the former, we do think that full employment stands closer to 3.5%. For this reason, the Fed will find it difficult to obtain its policy goal of full employment given the expected pace of rate hikes over the next 36 months.
The Fed in its projections updated its forecast of unemployment, reducing it to 4.3% from 4.8% this past September, and now expects it to move to 3.5% next year. The inflation forecast for the core personal consumption expenditures policy variable for this year now stands at 4.4%, up from 3.7%. It is now expected to be at 2.7% at the end of next year, 2.3% in 2023 and 2.1% in 2024.
The estimate of growth this year now stands at 5.5%, down from 5.9%. The growth forecast is now 4% for next year, 2.2% in 2023 and 2% in 2024.
