March FOMC preview: signalling a steeper interest rate path

16 Mar 2018

At next week’s FOMC meeting, the Committee will raise the target range for the Federal Funds rate, and follow through on its passive balance sheet run-off plan by further increasing the pre-announced caps for monthly Treasury and MBS run-off by $6 billion and $4 billion, respectively.  None of this will be a surprise to investors, given signaling from FOMC members that has reinforced expectations for a rate increase and that also indicates satisfaction with how smoothly balance sheet run-off has proceeded to date. As a result, the greater point of focus will be on the Summary of Economic Projections (SEP), and Chairman Powell’s first post-meeting press briefing. Since the December FOMC meeting, there have been a number of developments that inject a higher degree of uncertainty than usual into the projections. Specifically:

  • Final passage of the Tax Cuts and Jobs Act
  • Signs in communications that the Committee may have been too conservative in its initial assessment of the macro impact of the tax cuts;
  • A new two-year budget deal that will increase discretionary spending by over $200 billion (with most of the impact felt in 2019), though the appropriations bills still await finalization;
  • A pickup in core inflation readings;
  • Powell’s first Congressional appearance as Fed Chair, during which he expressed a bullish economic outlook while acknowledging that there are few signs of a meaningful pickup in inflation;
  • Increased market concerns about US protectionism;
  • Some moderation in hard economic data after a strong second half of 2017, while survey data still suggest a solid outlook.

In aggregate, this news flow suggests that growth, inflation and policy rate projections of individual members should all move higher. The question is, by how much, and are the shifts on policy rate projections enough to move the medians in the dot plot? My base case is as follows (with specifics in the table below):

  • Growth: A higher set of growth projections over the next three years, reflecting an upward revision to the estimated impulse from tax cuts plus incorporation of the new fiscal spending package. Overall contours of the path for GDP growth remains intact, i.e., a gradual decline over time towards a trend-like pace of growth.
    • No change in the longer-run GDP median. An upward revision will become a distinct possibility later in the year; for the time being the FOMC is watching carefully for signs that a tight labor market and business tax cuts are resulting in additional investment spending and, ultimately, productivity growth..
  • Unemployment rate: Slightly lower unemployment rate forecasts. Solid growth (and recent payrolls data) suggest an increase in the pace of payroll gains going forward, perhaps back to a sustained +200k per month pace this year. But positive news on labor force participation likely means that unemployment rate projections need not change significantly for now. I would look for another adjustment in June.
    • Downward revision to the longer-run unemployment rate median, by a tenth. I had expected this to happen in December, but at that point downward revisions by a number of participants were not enough to pull down the median. Recent commentary from FOMC participants suggest a further downward revision is likely, though admittedly recent firming in inflation numbers makes the cases a bit less compelling.
  • Core Inflation: Inflation in 2018 is off to a solid start, but the news on shelter inflation has been somewhat lackluster, and after disappointments in recent years the bulk of the Committee will be cautious about shifting their projections higher at this point. In addition, FOMC participants are likely to view the recent strength in apparel and health care prices as transitory. As a result, I see no change to core PCE projections for 2018 and the following two years, but the distribution of dots should shift higher as a number of participants revise their projections. The central tendency of projections for 2018 should shift from 1.7-1.9 percent to 1.8 to 2 percent, but I don’t see enough participants shifting their projections to move the median.  For 2019, the top of the central range of projections could shift to 2.1 percent – a welcome development that would, on the margins, reinforce the notion of symmetric treatment of the inflation objective.
  • Policy rate projections: I continue to expect 100 bps of tightening by the Committee this year, but I don’t expect this to be reflected in the SEP median projection until the June meeting, when there should be additional evidence of firming inflation as well as additional downward pressure on the unemployment rate. Looking at communications from Committee participants during the inter-meeting period, despite the bullish growth outlook and greater confidence in inflation projections, only two participants clearly shifted up their projected rate path for this year (Brainard and Bostic). Others have generally expressed greater optimism about the outlook but appear to be taking a wait and see approach for now. Even Powell acknowledged that there are few signs of imminent overheating, and suggested that NAIRU could be quite a bit lower than the 4.6 percent estimate of the median Committee participant. And since a third of current participants projected three rate hikes this year at the time of the December meeting, an increase in the median projection requires a large number of participants to shift their projections. And none of those that I believe projected 75 bps of tightening at the time of the December meeting have indicated anything more than confidence in the outlook while acknowledging the possibility that 100 bps of tightening this year may eventually be appropriate. Still, with some dovish members now projecting an additional rate increase this year, the average 2018 policy rate projection should move higher.
    • I expect some upward drift to the 2019 and 2020 median interest rate projections, reflecting the Committee’s greater comfort in moving to a restrictive policy stance by late 2019 to prevent the economy from overheating.
    • I do not expect a change to the longer-run policy rate or r*. This is certainly possible as the year progresses, but a shift at this meeting strikes me as premature.

My conviction in the above changes to the interest rate projections are not particularly high. The risk is that while only two participants clearly signaled a shift in their projected interest rate path, those communications may be indicative of a broader shift within the Committee. Under this interpretation, there would be a wholesale shift to higher projections for 2018 (and the median inflation projection for 2018 could also move up, to 2.0 percent). The median rate by the end of 2019 would not necessarily differ from what I expect, but the Committee would simply be front-loading those rate increases in order to push back against fiscal stimulus in a more proactive fashion. Keep in mind that ultimately this is what I expect to see reflected by the June meeting, but there is a risk that the shift happens now.

 

Figure 1. Expectations for the March summary of economic projections, and changes from the prior projection round

fomc_preview_chart

Source: BNP Paribas Asset Management, March 2018

 

As for the policy statement, there could be some hawkish signaling regarding inflation and fiscal policy. The statement could acknowledge that the pace of inflation has picked up in recent months, though if the Committee were to insert such language they would counterbalance it by continuing to acknowledge that the run rates of headline and core inflation remain below two percent on a year-over-year basis. The Committee might also choose to acknowledge the boost to activity over their projection horizon from fiscal policy. Otherwise, the statement will modestly downgrade its assessment of recent economic activity, particularly regarding consumer spending.

 

I expect Chairman Powell’s prepared press briefing remarks to follow the general message from his Congressional testimony – a number of tailwinds to growth, particularly stemming from fiscal policy; great confidence in the outlook for activity and inflation; and the need for the Committee to balance hitting its inflation objective with preventing an overheating of the economy. As such, I will be more attuned to the press briefing, especially if the subject of a policy framework shift comes up. Here I am most focused on whether Powell views a formal framework discussion by the Committee as a near-term priority. Finally, there has been some discussion of whether Powell will announce that he will hold press briefings after every FOMC. Powell may very well shift to such an approach over time, but I think he will be cautious about introducing this change now and instead will wait until he has a few press briefings under his belt and is comfortable with the amount of preparation required.