The Fed Raises Rates as Expected but the Path of Future Hikes Grows More Uncertain

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.

Finding neutral

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.