of the March 2018 Federal Open Market Committee (FOMC) meeting affirmed our
outlook that the Fed will likely continue to gradually and methodically
increase interest rates and that the bar is relatively high for
policymakers to change the current plan for two or three more hikes in
2018. Beyond this year, the policy picture is less clear but nearly all
FOMC participants now expect a mild overshoot of the inflation target by
2020 – although this doesn’t necessarily mean they are comfortable with a
more pronounced period of above-target inflation.
Policy rate outlook
The bar appears high to change the Fed’s current plan to hike interest
rates two to three more times in 2018. At the March meeting, most if not
all Fed officials upgraded their near-term outlook for U.S. economic
activity, citing more expansionary fiscal policy, solid global growth and
still easy financial conditions. And although a number of participants
thought a “slightly steeper” path of the fed funds rate was now warranted,
the committee was split as whether that meant two or three more hikes in
2018 and all participants agreed that it would “remain appropriate” to
maintain the gradual approach that has so far characterized the current
hiking cycle. While the prospects for retaliatory tariffs and a further
escalation in trade tensions were mentioned as a downside risk,
participants appeared to shrug off the increase in equity market volatility
since the beginning of the year.
Looking further out to 2019 and 2020, the policy picture is more uncertain.
Although several participants believed it would likely be appropriate to
raise the fed funds rate above its longer-run normal rate, there seems to
be uncertainty around what level of the fed funds rate is consistent with
neutral policy, and participants expressed a “range of views on the amount
of policy tightening that would likely be required over the medium term.”
The widely followed
Laubach and Williams natural interest rate model currently estimates the real neutral rate is around 0.0%, implying a 2%
neutral nominal fed funds rate is consistent with neutral policy. However,
uncertainty surrounding the model is great, and therefore the FOMC will
have to continue to assess changes in economic conditions resulting from a
gradual tightening of monetary policy to evaluate the neutral policy rate.
(For PIMCO’s latest views on The New Neutral for monetary policy, please
Cyclical Outlook, “The Beginning of the End?”
Forecasting above-target inflation by 2020
For the first time since the 2008 financial crisis, the
March Summary of Economic Projections (SEP)
reported that the median FOMC participant forecasts core inflation to
mildly overshoot (to 2.1%) the Fed’s longer-term target of 2.0%
year-over-year (as measured by Personal Consumption Expenditures or PCE) by
2020. To be sure, the expected overshoot was mild, but notable since it
coincided with material upward revisions to the median 2018 and 2019 real
GDP growth forecasts and downward revisions to the unemployment rate path.
The combination of these revisions suggests that many FOMC participants
believe that the appropriate monetary policy is one that does not
pre-emptively tighten to offset the strengthening tailwinds to growth,
including the more expansionary fiscal policies.
Still, on balance, the minutes leave us cautious about extrapolating FOMC
participants’ tolerance for above-target inflation. While a number of
participants suggested that a prolonged period of above-potential growth
could help anchor inflation expectations, they also worried that an
“overheated economy could result in significant inflation pressures or lead
to financial instability.” Fed policymakers won’t lose sight of their
Read PIMCO’s latest
Cyclical Outlook for insights into global economic growth and monetary policy in 2018.
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor
to the PIMCO Blog.