The Federal Reserve’s decision today to hike its policy rate by 25 basis points (bps) to a range of 1.75% to 2.0% was widely expected. The Federal Open Market Committee (FOMC) also signaled growing consensus that the robust pace of economic activity warrants two more rate hikes this year, for a total of four in 2018. But the elimination of forward guidance in the Fed’s statement, coupled with today’s announcement that it will hold a press conference after every meeting starting next January, is perhaps the most interesting aspect of today’s meeting: It underscores the Fed’s medium-term dilemma of how to set policy that sustains the expansion by balancing the risk of overtightening with the risk of overheating the economy.
Late-cycle fiscal stimulus, a flat Phillips curve and the high degree of uncertainty around the neutral interest rate – the rate at which the Fed is no longer accommodative and starts restricting the economy’s growth – complicate the Fed’s medium-term risk management task.
On the one hand, uncertainty over the neutral rate, coupled with the long lags needed for monetary policy to affect the real economy, argues for hiking gradually – or even pausing to assess the cumulative effects of the seven hikes, including today’s, since late 2015. The flattening Treasury yield curve could indicate that monetary policy is close to becoming restrictive, which could choke off growth more than the Fed intends.
On the other hand, late-cycle fiscal stimulus and still-easy financial conditions with unemployment at historically low levels raise the risk that inflation accelerates. If inflation expectations start to rise, the Fed could find itself in a nasty inflation spiral. As in the late 1970s and early 1980s, this could require a recession to restrain.
Focusing on overtightening could steepen curves and boost inflation-risk premiums
On its own, the elimination of forward guidance points to wider possibilities and more divergent views of the future path of the fed funds rate, as rates approach neutral. Today’s Statement of Economic Projections maintains the path of interest rate hikes will remain gradual (it showed an additional hike in 2018, but this was balanced by one less hike in 2020) and foresees only a small inflation overshoot. Taken together, this suggests that policymakers may still be slightly more focused on managing the risk of overtightening (while not ignoring overheating risks). Little evidence of U.S. financial market imbalances and well-behaved inflation also support this focus.
We continue to expect The New Neutral framework of low equilibrium policy rates will anchor Fed policy and U.S. fixed income markets. However, it’s important to keep the risks in mind. At a minimum, the Fed’s continued focus on managing the risks of overtightening and its stated commitment to a “symmetric” inflation target still argue for steeper interest rate curves, and higher inflation-risk premiums, as outlined in “Key Takeaways From PIMCO’s Secular Outlook: Rude Awakenings.”
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.