Going in to today’s meeting of the Federal Reserve, we and markets fully expected the Fed to hike, which indeed they did, shifting up the fed funds rate range by 25 basis points to 1.25% to 1.50%. This was the third hike this year and the fifth since this rate hike cycle began in December 2015.
Chair Janet Yellen liked to say that, thus far in this cycle, the Fed has been ”removing accommodation”, and we agree. With the policy rate still below the rate of inflation, monetary policy remains accommodative, but the gap between the fed funds rate and its “New Neutral” level is closing.
The Fed via its “dot plot” still sees a long-run neutral rate of 2.75%. And it is worth recalling that when Yellen became chair in 2014, the Fed thought the neutral fed funds rate remained at its pre-crisis Taylor rule estimate of 4%. The Fed’s thinking about the neutral policy rate has changed fundamentally in Yellen’s four years. And as we have written before, the Fed’s acknowledgment of a new neutral for monetary policy – and its reflection in market pricing – is one reason that 2017 was the year the Fed began to shrink its balance sheet but was not the year of “taper tantrum II”.
Unemployment and inflation down
In today’s update of its economic projections, the Fed revised down its estimate of the unemployment rate for 2018 to 3.9% from 4.1% and revised up its GDP growth forecast to 2.5% from 2.1%. The Fed continues to see a more than fully employed economy growing faster than trend.
That said, inflation continues to surprise on the downside as today’s CPI report confirmed, and perhaps for this reason there were two dissents, district bank presidents Neel Kashkari and Charles Evans. Under the Fed baseline, inflation rises gradually and smoothly to 1.99% and does not overshoot the desired inflation target of 2%. But in the past two rate hike cycles, in the 1990s and the 2000s, inflation did overshoot, which compelled the Fed to push the policy rate (well) above neutral.
“Goldilocks” markets discount this possibility, and this time may indeed be different. The Powell Fed is about to find out.
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Richard Clarida is PIMCO’s global strategic advisor and a frequent contributor to the PIMCO Blog.