Fed Outlook: Headwinds Shift to Tailwinds, But Pace of Hikes Still Gradual

The U.S. Federal Reserve’s announcement of another 25 basis point hike in the fed funds rate range to 1.5% to 1.75% was widely expected by us and by markets. The more interesting aspect of the March FOMC (Federal Open Market Committee) meeting is the change to central bank officials’ forecasts. Relative to December, the median path of Fed officials’ interest rate forecasts now incorporates two additional interest rate hikes between now and 2020, leaving the policy rate at a projected 3.4% by the end of 2020 – well above the Fed’s 2.9% median estimate of the longer-run rate. FOMC participants are now split on whether they will hike interest rates three or four times in 2018.

Despite the change in projections, the overall pace of rate hikes is likely to remain gradual relative to historical tightening cycles. Reinforcing this point, Chairman Jerome Powell pledged to “strike a balance” between the risk that the economy overheats with the risk that inflation expectations fall below the Fed’s 2% longer-term target.

Rate projections signify optimism over U.S. growth

The faster pace of rate hikes likely reflects a brighter near-term outlook for U.S. growth. Over the last few months, several FOMC participants have emphasized that the economic headwinds restraining growth in previous years have now turned to tailwinds. Since the December FOMC forecast update, congressional leaders achieved a sweeping rewrite of the tax code and a two-year government spending deal, which together should raise U.S. real GDP growth by a little more than half a percentage point in 2018 and 2019, according to our estimates.

These more expansionary fiscal policies have occurred against the backdrop of largely diminished U.S. labor market slack, a synchronized recovery in global activity and easier financial conditions, which have lifted U.S. exports and business investment growth.