The outputs of the September FOMC meeting came in very close to expectations. It turns out that most commentators were right about what they thought they knew, but there was limited information on the outstanding uncertainties. One journalist quipped "The Fed's mission to become the most boring institution in Washington is on schedule" and while that's a bit glib -- and unfair to a few other contenders -- it reflects how far the Fed has traveled in its post-crisis normalization process. It may prove to be an extended calm before the storm, as uncertainties mount regarding the outlook in late 2019 and beyond. This may not be as good as it gets, but here's what we've got.
What the Fed Did
- Hiked rates by 25 basis points, to a range of 2.00% to 2.25%, as expected.
- Simply removed the phrase about how "accommodative" monetary policy current remains, without further comment.
- Consolidated expectations for a fourth rate hike in 2018, but left the median dots for 2019 and 2020 unchanged; the median long-run dot was virtually unchanged and the median 2021 dot was unchanged from 2020's.
- Upgraded the GDP forecasts for 2018 and 2019, but forecast growth slowing back to trend in 2021, while the unemployment rate was forecast to rise only slightly in 2021.
What We Learned
- Skepticism about fiscal-driven shifts: The Fed still doesn't think that recent fiscal stimulus will increase the long-run potential of the U.S. economy. They project GDP growth will decline from 2.0% in 2020 to 1.8% in 2021, in line with the long-run potential rate -- before either the unemployment or the policy rate converges to its estimated long-run level.
- The 2020 battle lines are forming: The 2020 dots showed a new bifurcation (after the extremes moved inward), beginning to consolidate around 3.1% vs. 3.6%.
- The terminal rate is around 3.375% and pausing at a neutral rate is primarily a 2019 issue: Leaving the median dot for 2021 unchanged with respect to 2020 confirms that the Fed's policy rate is unlikely to rise beyond 3.375% (at least not materially and not for long). In fact, some Fed decision makers expect the policy rate to begin declining in 2021, as GDP slows back to trend and unemployment begins to inch up. If it takes restrictive policy to push unemployment up, and we assume it takes 12 months for restrictive policy to transmit through the economy, then the Fed should have hit or overshot neutral by sometime in 2019. All of this seems to align with market expectations for the Fed to hike twice in the first half of 2019, followed by 18 months of uncertainty, although the market continues to anticipate fewer rate hikes next year than the Fed.
- Normalization of the Fed statement: As Chairman Powell explained in his press conference, the "accommodative" phrase was originally introduced to offset the Fed's adjustments to its balance sheet. Retiring this phrase and shortening the statement (down by half to about 250 words over the last 12 months alone) marks another step in the Fed's normalization process.
- Normalization of policy rates: There are now two dots landing directly on on quarter-point intervals in 2021, none in 2020, and all of them in the long run.
- The Fed's current reaction function. Here are some tidy reminders, per Powell's press conference:
- Signs of supply-side constraints include (1) slowing job growth or GDP, (2) unexpectedly sharp growth in wages in inflation, and/or (3) sharp tightening in financial conditions.
- Reasons the Fed might speed up rate hikes: mainly if inflation surprises to upside but Powell seemed confident on this point, noting that the FOMC participants "really don't see that" happening.
- Reasons the Fed might slow down rate hikes: significant correction in financial markets or slowing in the economy.
What Comes Next
- Distribution of hikes in 2019: This could get interesting -- market-implied probabilities for a hike in May are already rising. The market is responding to the Fed's announcement that starting next year, press conferences will be held after every meeting (not just quarterly ones).
- Surveillance of asset prices and financial markets: In his press conference, Powell said that while some asset prices are at the upper ends of their historical ranges and corporate leverage is elevated, the risks appear "relatively moderate" right now. He poo-pooed risk to banks from syndicating leveraged corporate loans, although he omitted the possibility that banks may still retain risk in the fine print of the syndication contracts.
- Surveillance of trade tensions: Powell said that for near-term impacts from trade tensions, he would focus on stumbles in business confidence and investment, as well as financial markets.
- More new dots: Mary Daly will take over at the San Francisco Fed next month, and will submit her own dots in December. Three nominations to the Fed's Board of Governors remain outstanding.
- Allocating the uncertainty and the wisdom of crowds? At the same time that the Fed has been firming up expectations for the near-term rate outlook, Powell and other Fed veterans have been downplaying the significance of the forecasts for 2020 and beyond. That pushes uncertainty -- and speculation by financial market participants into the 12+ month time frame, where economic forecasting power really drops off. Intentionally or not, this functions as a kind of division of labor, in addition to providing near-term financial market stability. Economists aren't very good at forecasting the medium term, but policy makers can extract information from markets, and they can extract higher-quality signals about the medium-term expectations if the near-term is clearer.