Amid strong momentum in the economy and inflation virtually at the Fed’s longer-run 2 percent inflation target, the Fed is expected to increase its policy rate to 1.75 to 2.0 percent at the conclusion of its June 12-13 FOMC meeting, and announce the next step in its balance sheet normalization policy. Beginning in July, it will roll over maturing US Treasury securities that exceed $24 billion (up from $18 billion) during each calendar month and reinvest principal mortgage-backed security payments that exceed $16 billion (up from $12 billion). The Fed will also publish its quarterly Summary of Economic Projections and Fed Chairman Powell will host his second post-meeting press conference.
Regarding the economy: Momentum has picked up markedly from the first quarter. I expect second-quarter real GDP to increase at a 3.5 to 4.0 percent annualized rate compared to 2.2 percent in the first quarter, lifting the average growth in the first half of 2018 above the Fed’s 2.7 percent forecasted pace of growth for the year (fourth quarter to fourth quarter).
The Atlanta Fed GDPNow, a running estimate of GDP growth, estimates annualized second quarter GDP real growth at 4.6 percent. I expect the median FOMC estimate for 2018 fourth quarter to fourth quarter growth to remain unchanged from its March forecast of 2.7 percent, as FOMC members wait to see if the current economic momentum can be sustained. Of note, I also expect the Fed to leave its estimate of longer-run potential growth at 1.8 percent. The risk is that the Fed’s GDP forecasts will be revised upwards rather than downwards.
Regarding inflation: Headline PCE (personal consumption expenditures) inflation is already at the Fed’s 2 percent target and above its 1.9 percent forecast. Core PCE inflation of 1.8 percent, which excludes food and energy prices, is slightly below the Fed’s 1.9 percent forecast. Accordingly, I expect the FOMC’s median 2018 and 2019 PCE inflation forecasts to rise to 2.1 percent from 1.9 percent and 2 percent, respectively, and the 2020 median forecast to remain unchanged at 2.1 percent, and the median core PCE inflation forecast to increase to 2.0 percent from 1.9 percent, but the 2019 and 2020 medians to remain unchanged at 2.1 percent. I forecast inflation to rise modestly higher than the Fed projects, which will place the Fed in an awkward situation if healthy economic growth and low unemployment are sustained.
Regarding unemployment: Since the Fed’s March Summary of Economic Projections, the unemployment rate has fallen by 0.3 percentage point to 3.8 percent, its year-end estimate. Accordingly, I expect the FOMC’s median forecast for the unemployment rate at year-end 2018 to be reduced to 3.7 percent and to 3.5 percent from 3.6 percent in 2019 and 2020. This is nearly a full percentage point below the Fed’s “full estimate” of 4.5 percent, which should lead more FOMC members to raise their inflation or policy rate forecasts.
The Fed’s forecasts of the appropriate path of the Fed funds rate: I continue to expect four rate increases this year—one each quarter—while through March, the FOMC members were fairly evenly split between three and four.
I see the Fed tilting toward four hikes in its updated assessment of the appropriate path of the Fed funds rate. The Fed is likely to keep its assessment of the longer-run rate at 2.9 percent, but can be expected to lift that estimate if healthier growth in capital spending and productivity gains is sustained.
The Fed’s official Policy Statement will likely reflect the Fed’s more upbeat assessment of current economic and labor market conditions, characterizing the unemployment rate as having “declined” in recent months as opposed to “stayed low,” and describing household spending as “growing strongly” from “moderated from its strong fourth-quarter pace.” As hinted at in its minutes from its May FOMC meeting, the Fed may be ready to revise the forward-guidance language in its statement that reads, "federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run." The Fed may either remove this phrase completely, or change it to reflect its projection that a 2020 policy rate of 3.4 percent, which is above its long-run 2.9 percent estimate, will be appropriate.
Fed Chair Powell, in his press conference, is expected to characterize the healthy momentum in the economy as the rationale to maintaining a gradual pace of normalization. The Fed may indicate that in the future the Chair will hold a press conference at the end of every meeting, indicating to markets that the Fed does not want to be constrained to change its policy rate only at quarterly meetings.
Amid strong economic momentum, near-2 percent inflation and sub-4 percent unemployment, the Fed may send the wrong signal if it pauses policy normalization. The Fed has been slow to revise up its economic forecasts and continues to anticipate that the largest portion of the stimulus from the Tax Cuts and Jobs Act is temporary, and also seems to be understating the positive impacts of the thrust toward deregulation. However, I expect these policy changes will have a more sustained economic effect.
Mickey Levy is the chief economist for the Americas and Asia of Berenberg Capital Markets, LLC, and member, Shadow Open Market Committee.
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