Fed raises interest rates, signals it'll raise rates again

Wed, Sep 26, 2018, 11:00 AM

The most notable change in Wednesday’s statement was the removal of language indicating the Fed sees its policy as “accommodative.” In its August statement, the Fed said, “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.”

The removal of this language indicates that Fed officials see their current interest rate policy as nearing the level that is estimated to sustain full employment while meeting the Fed’s 2% inflation target.

As it did in its August policy statement, the Fed described the economy as “strong” in at least three different areas, writing that information since the Fed’s August meeting shows, “the labor market has continued to strengthen and that economic activity has been rising at a strong rate.”

The statement adds, “Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly.”

Summary of economic projections

The Fed’s statement on Wednesday also included the release of updated economic projections from members of the Fed’s Board of Governors and regional Fed presidents.

The most notable change in this set of projections is a steep upgrade in expectations for economic growth this year. Fed officials’ median forecast now calls for GDP growth to hit 3.1% in 2018, up from 2.8% in June’s projections and substantially higher than the Fed’s forecast for 2.5% GDP growth this year at the end of 2017.

The Fed’s latest dot plot also reveals that officials are split on the path of interest rate hikes next year and beyond.

With 12 of 16 Fed officials forecasting another rate hike in 2018, December’s meeting will likely come and go without any fanfare. In 2019, however, four Fed officials expect two rate hikes, four Fed officials expect three rate hikes, and four Fed officials see four rate hikes as likely being appropriate. The dot plot also reveals outliers on both ends of these outcomes.

In 2020, the Fed’s median dot indicates one rate hike will likely be warranted before the range of outcomes widens significantly in 2021, with the median dot forecasting a decrease in benchmark rates from the level expected at the end of 2020.

The latest dot plots also shows the longer run interest rate estimated to sustain full employment and 2% inflation is likely somewhere between 2.5%-3%. Six Fed officials see 3% as the longer run neutral rate, with four officials pegging the neutral rate at 2.75%, and three officials seeing 2.5% as the longer run neutral rate.

This forecast indicates that perhaps as soon as next year Fed policy will move to being restrictive, with benchmark rates set higher than what officials estimate will be required over the longer run.

The new dot plot, in addition to increasing communication from the Fed about its policy decisions, creates a degree of unpredictability over when the Fed may raise interest rates. Since the crisis, markets have only priced in a rate hike at one of the Fed’s quarterly meetings followed by press conferences. Fed Chair Jerome Powell said at the Fed’s June meeting that beginning in January 2019, Powell will host a press conference after each of the Fed’s 8 annual meetings.

The summary of economic projections also provided investors with their first look at Fed officials’ forecasts for 2021, with economic growth expected to slow down to 1.8% with an unemployment rate of 3.7% and core inflation running at 2.1%.

Over the longer run, officials still see the economy growing 1.8% while a 4.5% unemployment rate is expected to sustain 2% core inflation. The Fed’s 2021 forecast indicates that while Fed officials expect the economy to slow over the coming years, a recession is not expected through at least the first two years of the next decade. Additionally, Fed officials believe it will have to increase unemployment in order for the central bank to sustain inflation at its 2% target.

IOER tweak stays

In keeping with a change the Fed first made in June, the central bank set the interest paid on excess reserves (IOER) 5 basis points below the desired ceiling for the Fed funds rate. As of September 27, the interest rate on excess reserves paid to banks will be 2.2%, up from 1.95% previously. Since June, the Fed funds rate has been around 1.91%, 5 basis points below the previous IOER rate and 10 basis points below the prior Fed funds ceiling. This technical tweak has provided the Fed alarger cushion between the effective rate and the ceiling of the Fed’s targeted range.

The Fed on Wednesday also said it will increase the monthly caps of its balance sheet shrinkage by $10 billion per month beginning in October, bringing the total monthly reduction of its balance sheet to $50 billion from $40 billion as of June.