Flatlining the Fed
We have removed the one fed funds rate hike for 2019 that we had previously shown in our interest rate forecast. In our February interest rate forecast, we had one fed funds rate hike coming at the June FOMC meeting. Now, in our March interest rate forecast we show the fed funds rate range remaining at the current 2.25-2.50 percent through 2021. This reflects our uncertainty about both the timing and the direction of the Fed’s next move.
In his 60-Minutes interview from March 5, Fed Chairman Jay Powell again emphasized the Fed’s “patient” stance. Powell said, “Patient means that we don’t feel any hurry to change our interest rate policy.” Powell’s chief justification was a cooler global economy and he highlighted downside risks emanating from weaker demand in China and Europe and from the Brexit process in the U.K.
The flattening of the Treasury bond yield curve early this year is consistent with the view that the Fed is at the top of its rate tightening cycle. Also, the fed funds futures market shows a strong implied probability, 77.6 percent, that the fed funds rate range will remain at the current 2.25-2.50 percent through January 2020.
Flatlining the fed funds rate is also consistent with our view of cooler U.S. economic growth through the remainder of this year. We now expect U.S. real GDP growth to ease from 2.9 percent in 2018, to 2.5 percent in 2019, and ease further to 2.2 percent in 2020. While we are forecasting continued U.S. economic growth through the near term, we also recognize that the odds of recession for the U.S over the next two years have materially increased.
Finally, we can say that a flat fed funds rate forecast is consistent with expectations for overall lower interest rates in this expansion cycle. R-star (or R*) is the terminology that the Fed uses to denote the “natural “ rate of interest. It is more tightly defined as the real (inflation-adjusted) short-term interest rate expected to prevail when the U.S. economy is at full strength and inflation is stable. R-star is not directly measurable. It is only a theoretical construct. But the concept shows how the Fed’s thinking about interest rates has gradually changed over recent decades. The Fed’s estimates for R-star have dropped significantly from about 3.5 percent in the late 1980’s, to about 0.8 percent at the end of 2018. This estimate of R-star at 0.8 percent, plus inflation in the neighborhood of 2.0 percent, gives us an estimate of about 2.8 percent for a “neutral” fed funds rate. This is why the Fed thinks it is already close to neutral and is concerned about overshooting neutral if the global economy cools down and inflation falls.
Inflation is now the key variable in the Fed’s policy calculation. The Fed’s preferred measure of inflation, the 12-month trimmed mean PCE price index has been hovering near 2 percent since last June. Even though oil prices have firmed early this year, they will likely exert little upward pressure on the trimmed mean PCE because big pushes and pulls in inflation are dropped out of the index so that it represents a “core” reading on prices.
We expect overall inflation to remain calm, near 2 percent, for the remainder of this year, effectively removing the rationale for further rate increases. Wages are still going up due to the tight labor market, and there is still some upside risk to inflation from the Phillips Curve effect, that higher wages will eventually result in hotter inflation. However, to date, that remains a risk and not a fact. Further, the potential resolution of the U.S./China trade war this year represents a key downside risk for inflation.
On March 20, the Fed will release a new dot plot showing the FOMC’s expectations for the fed funds rate over the next few years. We expect to see the March dot plot flatten compared to the dot plot from last December.
For a PDF version of this report, click here: March 2019 U.S. Economic Outlook
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