Tighter financial conditions and slower global growth have weakened arguments that U.S. monetary policy will be restrictive in the coming years to alleviate the risk of economic overheating or growing financial imbalances. However, in line with our expectations, recent market volatility was not enough to change FOMC (Federal Open Market Committee) participants’ views that the outlook for above-trend U.S. growth in 2019 necessitates neutral monetary policy. In the end, Wednesday’s FOMC statement, updated economic projections and Chairman Powell’s press conference brought the committee more in line with our outlook for one to two interest rate hikes in 2019.
Subtle but important shifts in Fed communication
As expected, the Fed on Wednesday raised its policy rate by 25 basis points (bps), bringing the effective fed funds rate just below the Fed’s 2.5% to 3.5% range of estimates for neutral monetary policy. The Fed also modified its previous statement language, now noting that only “some” further gradual increases are necessary, to allow for greater uncertainty and more flexibility about the future direction of interest rates as the Fed enters the range of estimates for neutral policy.
Perhaps more interestingly, in the Summary of Economic Projections (SEP), FOMC participants downgraded their expectations for the appropriate path of monetary policy, resulting in a 25 bp decline in the level of the median path in 2019, 2020 and 2021. The median participant also downwardly revised their 2019 growth and inflation expectations, and, notably, the median core PCE inflation forecast is no longer above the committee’s longer-run 2% inflation target (PCE, or personal consumption expenditures, is the Fed’s preferred inflation measure).
Overall, we view these revisions as largely consistent with our estimates of the economic implications of the recent tightening in financial conditions. Indeed, we estimate that tighter financial conditions since the September SEP could reduce 2019 real GDP growth by 0.3 to 0.4 percentage points – a little more than the FOMC’s median forecast revision, which brought down their 2019 real GDP forecast to 2.3% annualized (from 2.5% previously). However, it’s important to keep in mind that despite the revision, PIMCO and most FOMC participants continue to expect that above-trend real GDP growth will push the unemployment rate lower, necessitating a neutral stance for monetary policy.
The policy rate path in 2019
Exactly where rate hikes will stop in 2019 is still up for debate. With the current range of estimates for neutral policy between 2.5% and 3.5%, one, two or three hikes are still possible, and the SEP unveiled that the committee is currently split among all those possibilities. At PIMCO, we continue to view one to two hikes in 2019 as more likely, as we believe fading fiscal stimulus, rising headwinds from slower growth in China and elsewhere and tighter financial conditions will weigh on growth next year.
And while it’s possible that elevated volatility in financial markets could prompt some discussion of skipping a rate hike in March only to resume hikes in the second half of 2019, we think this strategy would be difficult to communicate and execute. If the U.S. outlook deteriorates enough to warrant a change in the outlook, any marginal economic benefit from remaining on hold in early 2019 would likely be offset by the Fed signaling additional rate hikes for the second half of the year. In our view, a more consistent approach would be to maintain the current monetary policy strategy of hiking rates into the range of neutral, unless incoming data materially change the outlook.
For our detailed views on the interest rate outlook and its implications for investors, please see “Rise Above Rising Rates.”
Tiffany Wilding is a PIMCO economist focusing on the U.S. and is a regular contributor to the PIMCO Blog.