The Federal Reserve meeting this week will be the first under its new policy framework of average inflation targeting. While the Fed is in the process of moving toward forward guidance organized around inflation outcomes, we do not expect the central bank to announce the principles around which such a decision will be put forward.
We anticipate that the Fed will view both output and employment as remaining well below potential.
Given the new framework, we anticipate a new policy on forward guidance. But with the uncertainty around the forecast and a variety of metrics pointing toward a downside risk to the inflation target, this will need to be addressed by the committee in the near term.
We expect that will be done at the December meeting. This week the focus will be on an update of the summary of economic projections, the first look at the Fed’s 2023 forecast and a reiteration that the Fed will keep the policy rate effectively at zero until the economy has recovered.
The committee will reiterate its stance from the July statement noting an increase in economic activity and employment, while pointing toward the considerable risks around the outlook linked to the pandemic. We anticipate that the Fed will view both output and employment as remaining well below potential.
Accordingly, the Fed will continue to emphasize that it will target a policy rate of 0.125% until it is confident that the “economy has weathered recent events and is on track to achieve its maximum employment and price stability goals.”
The summary of economic projections will feature an upgrade to both the 2020 growth and unemployment forecasts. The June median projection of a 6.5% decline in gross domestic product will most definitely be upgraded to likely near minus-5%, and the end-of-the-year forecast on unemployment will probably be revised to reflect a better outlook of near minus 7.9%, in contrast with the decline of 9.3% previously.
Additionally, the Fed will certainly be raising its 2021 and 2022 growth and employment forecasts, setting the stage for an interesting estimation on how long it will take for the economy to return to its full potential.
The dot plot, or interest rate forecasts, will most likely point toward a sustained policy rate at 0.125% until the end of 2023. While we are not as dour as the Congressional Budget Office, which does not see a return to full potential until 2028, we do expect that it will be the middle of the decade before actual output equals full potential.
When all is said and done, we expect the summary of economic projections to imply long-run potential growth of 1.8%, full employment at 4% and the neutral rate of interest at 2.5%, all of which point to years of dovish central bank policy ahead.
The Fed will almost surely leave the size and composition of its asset purchases unchanged, and the language in the statement will note that it expects those purchases to continue “over coming months” to support a stronger economic recovery.
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