The Federal Open Market Committee will leave its policy rate unchanged at its meeting this week, but that decision will mask an underlying shift in its economic projections and policies. Consider three areas where this shift is occurring:
- The dot plot, which shows committee members’ projections for the federal funds rate, will most likely pull forward expectations of an interest rate hike into the final quarter of 2023.
- Tapering, or the reduction of monthly asset purchase, will enter the conversation as the Federal Reserve begins to lay the groundwork for gradually reducing these purchases early next year.
- The Summary of Economic Projections will show an acceleration in the Fed’s growth and inflation forecasts.
In our estimation, the formal talk on tapering—remember the reduction of monthly asset purchases is not tantamount to tightening—will not begin until the Kansas City Fed’s Symposium on Monetary Policy at Jackson Hole, Wyo., in late August.
The statements of Federal Reserve Chairman Jerome Powell at his news conference on Wednesday will most likely be far more important with respect to the benchmark 10-year yield—it dropped from 1.74% on March 31 to a recent low of 1.43%—than any decision to change its top-line policy rate of 0 to 25 basis points. It’s also possible that the upgrade to the growth forecast will prompt the Fed to make an increase of 5 basis points in the interest rate it pays on excess reserves and the overnight reverse repurchase rate.
Dot plot
On the publication of the FOMC’s policy statement and the accompanying Summary of Economic Projections, investors and market players will immediately gravitate to the “dot plot” forecast of the policy rate.
We expect that the improvement in growth and a greater-than-anticipated increase in prices will combine to move just enough of the Fed to pull its expectation of the first rate hike into the final quarter of 2023, which is in line with our updated forecast.
In addition, the recent increase in the Consumer Price Index to 5% will almost surely cause enough of the neo-hawkish members of the Fed to pull their forecasts of the first rate hike into late 2022. That will result in a greater focus on when the Fed begins to slow, or change the composition of, its $120 billion in monthly asset purchases.
Tapering
The Fed will make no reference in its statement to altering its purchases of $80 billion in Treasury bonds or $40 billion of mortgage-backed securities every month. But in the news conference, we do expect some talk around tapering and the Fed making “substantial further progress” that will result in the actual start of tapering. While the Fed will surely discuss the ideas around tapering at the meeting, it will not appear as a formal policy objective until the September statement.
Summary of Economic Projections
Traditionally, changes to growth and inflation forecasts are front and center at FOMC meetings. But given the unusual context of the post-pandemic economy and the memory of the Fed around the damage caused by the 2013 taper tantrum, the focus of investors and other policymakers will be on the news conference and any hint of tapering.
That being said, we expect the median growth forecast on gross domestic product, which was 6.55% in the March Summary of Economic Projections, and the estimate on the Personal Consumption Expenditures inflation forecast of 2.4% to be revised higher on the back of first-quarter GDP data and second-quarter inflation data.
Perhaps more interesting will be if the Fed changes its median inflation forecast of 2.1% for 2023. We do not anticipate any changes to the Fed’s estimation of the neutral interest rate (R*) or the non-accelerating inflation rate of unemployment.
Front end of the curve
There has been lots of noise and ink spilled over the past few weeks around the Fed’s efforts to keep its policy rate and the front end of the curve from falling into negative terrain.
The Fed has said that it is willing to act as it finds necessary and does not think it needs to wait until a formal meeting to increase the interest it pays on excess reserves and the overnight reverse repurchase rate. We expect the Fed will shy away from taking action on this market concern, but it is a close call.
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