Fed Accompanies a Rate Increase with a Stronger Outlook and a Call for a Fourth 2018 Hike
by Craig Dismuke, Dudley Carter
As expected, the Fed unanimously voted to raise its target range for the seventh time this economic cycle to a range of 1.75% to 2.00%. The Statement was changed to upgrade the growth rate from “moderate” to “solid” and remove a statement saying the target rate would remain below the neutral rate “for some time”. In the SEP, the change likely to draw the biggest headlines was the projection of four rate increases this year instead of three.
In the Statement, the Fed acknowledged the decline in the unemployment rate and credited a pick-up in household spending for the stronger pace of activity. The second paragraph was confidently re-worked to project further gradual rate “increases” (previously “adjustments”) to sustain the economic expansion, strong labor market, and near-target inflation. Interestingly, despite the more optimistic Statement and projections (more below), the risk assessment remained “roughly balanced”. In the forward guidance, a sentence pledging a careful monitoring of inflation developments was removed as was the statement that the target rate is expected to “remain, for some time, below levels that are expected to prevail in the longer run.”
More interesting was the SEP. The median estimate for growth this year was revised up from 2.7% to 2.8% while subsequent years were left unchanged. As expected, the estimate for unemployment at the end of 2018 was lowered to 3.6% (-0.2%) while the forecast for 2019 and 2020 were both dropped 0.1% to 3.5%. The NAIRU rate remained at 4.5%. Headline PCE inflation is expected to run at 2.1% through 2020 (+0.2% for 2018, +0.1% for 2019) while core was seen ending this year at 2.0%, 0.1% higher than in March. The outworking of the stronger growth outlook and, potentially to a greater degree, the lower unemployment rate, was the addition of a fourth hike for 2018. A single official raised their 2018 dot to 2.375%, but it was enough to move the median. The Fed continued to call for three more rate hikes in 2019, meaning the overnight rate is now expected to end next year at 3.125% instead of the 2.875% forecasted in March. The 2020 median dot was unchanged at 3.375% and the longer run rate held at 2.875%.
In the implementation note, the Fed did raise the rate it pays on excess reserves by just 0.20% to 1.95% in order to direct the effective rate closer to the middle of the range. And as expected, they adjusted the directive for managing the portfolio to allow for up to $30 billion in balance sheet roll-off starting in July.
Markets, which had leaned slightly in favor of a more dovish outcome ahead of the announcement (stocks were flat but Treasury yields were lower and the Dollar weaker), reversed on the more hawkish decision. Stocks declined, the Dollar reversed its losses to turn positive, and Treasury yields rose in a flattening fashion. The 2-year yield was up 4.3 bps while the 10-year yield added 2.8 bps, pushing the spread briefly below 40 bps.
Bottom line: The Fed hiked, hawkishly added a fourth rate increase for 2018, and kept their call for three additional hikes in 2019. Those changes were in response to a stronger growth outlook, an even tighter labor market, and a quicker-than-expected return of core inflation to the 2% target. The cumulative results reflect a bit of a paradigm shift from the FOMC. They have been in a tightening mode 1) to get away from an “emergency policy” position 2) in anticipation that the economy was strengthening. They now appear to be tightening because they believe 1) the economy is at full capacity with the expectation that 2) they are keeping it from running too hot.