Fed Policy: Patience Is a Virtue

Following its March meeting, the Federal Open Market Committee (FOMC) released a statement and summary of economic projections (SEP). Meaningful upgrades to the Fed’s real U.S. GDP growth forecasts translated into only modest upward revisions to the medium-term core inflation forecasts and no change to the projected median policy rate path.

In our view, these changes illustrate the Fed’s commitment to its new monetary policy strategy. Before hiking interest rates, FOMC members want to see an inclusive recovery: A 3.5% unemployment rate by itself isn’t sufficient to hike rates, and actual and sustainable inflation above 2% is necessary. The Fed’s messaging also clearly indicates that inflationary pressures that may develop in 2021 (resulting from shipping bottlenecks or other temporary factors) will not be enough for the Fed to hike rates.

All of this should help keep inflation expectations anchored, and could have the added benefit of further limiting longer-term scarring in the economy.

A brighter outlook

Since December 2020, several developments led Fed officials to upgrade their economic outlooks: positive economic data, encouraging health trends (COVID-19 vaccinations, caseloads, and hospitalizations) leading to fewer restrictions, and most importantly, the surge in federal spending on COVID-19 relief. The Fed’s median 2021 real GDP forecast rose to 6.5% (versus 4.2% projected in December), and the unemployment rate forecast was revised down to 4.5% for 2021. Upgrades to the 2022–2023 projections were more modest, but we note the FOMC forecasts the unemployment rate will reach its pre-pandemic level by the end of 2023.

The Fed’s revised growth outlook did not translate into a large upward revision to their expected path of inflation. (For details on the factors we think will keep inflation in check, please read our February blog post.) Nonetheless, the median forecast did include a small inflation overshoot (to an annualized rate of 2.1%) beyond the Fed’s 2% target projected in 2023. (The Fed’s preferred inflation measure is PCE – personal consumption expenditures.) The Fed acknowledged the possibility of temporarily higher inflation this year due to the speed of the recovery, relatively low consumer goods inventories, and global freight bottlenecks. However, it also confirmed that it will not tighten monetary policy in reaction to that. Consistent with this, in recent speeches, the FOMC leadership has emphasized secular disinflationary pressures, including advances in technology and the flatness of the Phillips curve, to explain why market participants shouldn’t assume the Fed will be quick to hike interest rates in response to incipient inflation signals.

Despite the brighter economic outlook, the median fed funds rate expectation for 2023 remained unchanged at 0.125%. Several members revised higher their rate projections; however, a majority of the FOMC still expects it will be appropriate for the fed funds rate to remain at the effective lower bound through 2023.