US monetary policy – how things stand going into the second half

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The latest FOMC meeting of US monetary policymakers saw a further increase in the fed funds rate, while the guidance signalled continued comfort with a modest inflation overshoot, but the projections flagged up an additional interest-rate increase in 2019 over and above what had been pencilled in so far.

This meeting was the third led by Jerome Powell and it considered the second set of updates to the Summary of Economic Projections (SEP) since he took office.

Observations from the SEP and the FOMC policy statement

  • As expected, the FOMC raised the policy target rate by 25bp to 1.75-2.00%
  • FOMC projections for the future path of policy rates were adjusted, with the median for 2018 shifting from three to four rate increases. The end-2019 median projection was raised from 2.9% to 3.1%, indicating faster progress to restrictive policy.
  • The end-2019 median projection for the unemployment rate was lowered from 3.6% to 3.5%, taking the projection further below the non-accelerating inflation rate of unemployment (NAIRU).
  • As expected, the committee deleted the forward guidance phrase, namely, “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run”.
  • The statement dropped the reference to rates staying below neutral for “an extended period,” reflecting the fact that the policy rate is now merely 100bp from the FOMC’s estimate of ‘neutral.’

Our conclusions

  • The change in interest-rate projections was mildly hawkish relative to market expectations. Going into the meeting, most investors appeared to expect that the median policy rate projection for 2018 to increase by 25 bp, reflecting 100bp of cumulative tightening this year. And that is indeed what occurred. But the additional rate increase projected for next year was not at all widely anticipated. The median rate path now reflects policy moving into restrictive territory in 2019. But for us, this is only mildly hawkish relative to market expectations as the median projected end-2020 policy rate did not change. In effect, the FOMC is just anticipating moving into restrictive territory a bit earlier.
  • Overall, we took Powell’s comments to suggest continued comfort with a modest inflation overshoot – as he said, “we won’t overreact to inflation being above two percent” and “we expect inflation will be above or below [two percent]”, but he also stressed that persistent deviations from the objective are not acceptable.
  • Our economists conclude that the FOMC will likely remain on a gradual tightening path so long as inflation is projected to remain at around 2.25% or lower.  It is not trying to be overly precise about the Fed’s tolerance threshold. Instead, it stresses that at some point, the Fed will become increasingly concerned about the challenges of bringing down pro-cyclical components of inflation such as the cost of shelter without causing a recession. And we think this inflation threshold is a good deal south of 2.5%.
  • Powell poured cold water on the idea that the FOMC is actively considering a framework change that would lead to higher average inflation over time. For example, when asked for his thoughts on a move to price level path targeting, he said that the FOMC would likely consider this at some point, but it is “not something we have on the calendar right now.”

(with contributions from Steve Friedman)

*This article is an extract from the Inflation Linked Bond quarterly outlook for the third quarter of 2018

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