We expect the Federal Reserve to keep the federal funds policy rate in a range between 3.50% and 3.75% when the Federal Open Market Committee meets on Wednesday.
At the same time, as the energy shock is felt in the domestic and global economies, we expect the Fed to raise its inflation forecast and reduce its estimates for growth and employment.
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Expect a lively news conference after the meeting as Fed Chair Jerome Powell not only fields questions about the energy shock but also addresses his status at the Fed. His term as chair ends in May, but his term as a member of the FOMC ends in January 2028.
The FOMC’s revised outlook on pricing and growth will be reflected in its statement and in its Summary of Economic Projections as the war in Iran injects further uncertainty to the bank’s dual mandate of price stability and maximum sustainable employment.
Expect Powell to counsel patience as central bankers take a wait-and-see approach on the impact and duration of the war.
We think that the dot plot, which is the FOMC members’ interest rate forecast, will continue to reflect one 25 basis-point cut this year. But it will be a close call given the risk of rising inflation.
In the years that follow, we expect the median estimate to drift down toward the 3% terminal rate projected by the Summary of Economic Projections.
We expect the Fed to raise its forecast for the personal consumption expenditures index, both in the top-line figure and in the core rate, to near 3% while bringing down its estimate of growth from 2.3% to 2.1%. We see the unemployment rate forecast for this year being lifted to 4.6%.
At the news conference, expect Powell to note that the Fed will look through an increase in inflation but will add that monetary policy going forward will be conditional on inflation expectations remaining well anchored.
In addition, expect aggressive questioning on Powell’s status and the duration of his term at the Fed. There is a growing likelihood that Kevin Warsh, the nominee to succeed Powell as chair, will not be confirmed by the time Powell’s term as chair ends in May.
It would be in the best interests of the Fed and Powell if he offers a reminder that the Fed can do only so much to counter the impact of an energy shock. While it can take action to address a financial crisis by printing money and injecting liquidity into the financial system, it cannot print oil.
In many ways, an energy shock is a central banker’s nightmare as it creates tension between a shaky labor market and rising inflation.
A simultaneous increase in prices, rising unemployment and decline in aggregate demand create a toxic supply-side mix that central bankers are ill equipped to address.
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.
At best, the Fed will seek to mitigate any second-order effects from that tension by keeping the policy rate where it is. Any downward impact on demand must be weighed against the risk that firms will pass on cost increases and that labor attempts to protect real wages.
Businesses will most likely face a difficult decision on how to bring their balance sheets into alignment with a changing cost structure caused by the oil shock.
Thinner profit margins, price increases and layoffs are now in view, which will not be lost on central bankers.
The takeaway
The key point is that the Fed tends to look through short-term volatility in oil prices and will wait and see how the current conflict plays out.
If top-line inflation bleeds into core pricing and inflation expectations move higher, then the Fed could be faced with a difficult decision on hiking rates.
