The Fed raised its Federal funds rate by 25 basis point (bp) to 2.25–2.50% at its December FOMC meeting, as expected, but signaled a slower pace of policy rate increases going forward. For instance, it lowered its estimates of real GDP growth in 2018 and 2019 and modified its policy statement from saying that it expects “further gradual increases in the target range for the federal funds rate” to “some further gradual increases.”
The change to the Fed’s tone is a nod to the increased uncertainties, slower global growth, lower inflation and inflationary expectations, tighter financial conditions, and the flatter yield curve since it last published its Summary of Economic Projections (SEPs) following the September FOMC meeting.
This Fed funds rate increase is the fourth this year and the ninth since the start of the rate-hike cycle in 2015. For the first time since 2008, the funds rate is higher than core inflation and is just below the range of Fed members’ estimates of the longer-run rate (2.5–3.5%). After ten years of very accommodative policy, the Fed is finally approaching neutral.
The Fed maintained its balance sheet policy of unwinding up to $30 billion in Treasuries and $20 billion in mortgage-backed securities per month, as expected, and made no mention of what it intends the ultimate size of its balance sheet to be. The Fed’s securities holdings are currently $3.9 trillion and have shrunk by roughly $331 billion since the start of its balance sheet normalization in October 2017. The Fed’s balance sheet policy will come into greater focus next year as it reexamines its operational framework. The policy actions taken at this meeting were unanimously approved by the FOMC voting members.
The Fed maintained its optimistic assessment of economic activity and the labor market, noted that the unemployment rate has “remained low” as opposed to “declined,” continued to observe that headline and core inflation were running near 2%, and tweaked its forward guidance for the policy rate.
The Fed only slightly altered its description of the risks to the economic outlook from “appear roughly balanced” to “are roughly balanced” but hinted at greater emphasis on data dependence by saying that it “will continue to monitor global economic and financial developments and assess their implications for the economic outlook.” This was the Fed’s acknowledgment that risks have heightened without acknowledging that its assessment of risks is skewed to the downside.
The Fed maintained its assessment that market-based measures of inflation “are little changed,” despite the sizable drop in market-based measures of inflation expectations over the last two months.
As for future policy, we expect the Fed to increase the Fed funds rate only once in 2019, to 2.50–2.75%, most likely in the second quarter.
Summary of Economic Projections
Real GDP: The median FOMC forecasts for real GDP growth (Q4/Q4) were lowered in 2018 and 2019, to 3% and 2.3%, from 3.1% and 2.5%, respectively, but were unchanged for 2020 and 2021, at 2.0% and 1.8%, respectively. The Fed’s median estimate of potential GDP growth rose slightly to 1.9% from 1.8%. If real GDP continues to grow above the Fed’s current estimates of potential without generating an acceleration in inflation, if productivity growth continues to improve, and if the labor force participation rate for the prime working-age cohort continues to rise, the Fed will eventually further revise up its estimates of longer-run growth.
Unemployment rate: The median unemployment rate forecasts remained unchanged, at 3.7%, and 3.5% in Q4 2018 and 2019, respectively, but revised up slightly by 0.1pp to 3.6% and 3.8% in 2020 and 2021, respectively. The Fed lowered its estimate of the natural rate of unemployment only slightly to 4.4% from 4.5%. This change is smaller than we had expected. But the reduction implies that the Fed does not view the labor market as operating that much above “full employment” and that there is more room for solid employment and economic growth without generating concerning bottlenecks. This is a slightly dovish change.
Inflation: Median headline inflation forecasts for Personal Consumption Expenditures (PCE) were lowered to 1.9% in 2018 and 2019 from 2.1% and 2%, respectively, and core PCE inflation forecasts were lowered by 0.1pp to 1.9% in 2018 and by 0.1pp to 2% between 2019 and 2021, suggesting slightly less confidence in the inflation outlook.
Mickey Levy is the chief economist for the United States, the Americas, and Asia at Berenberg Capital Markets, LLC and a member of E21's Shadow Open Market Committee (SOMC). The views expressed in this column are the author’s own and do not reflect those of Berenberg Capital Markets, LLC.
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