Pressure Builds on the Fed to Raise Rates Faster
The unemployment rate continues to slide, hitting 4.4 percent in April. The Federal Reserve’s median forecast for joblessness -- 4.5 percent from the end of 2017 through 2019 -- has once again proved optimistic. But does this mean that Fed officials will hike their interest rate projections at the next Open Market Committee meeting?
Not necessarily. There are a lot of moving pieces in the Fed’s rate forecast, and there is a good chance that at least one of them will offset the impact of a declining unemployment rate. If there is no offset, then the central bank is making a pretty big bet that the economy is close to a tipping point that requires further tightening to keep the odds of overheating at a minimum.
It seems unlikely the Fed’s current unemployment forecast will survive in the next Summary of Economic Projections. Even the lowest of the projections for this year among the whole range of FOMC participants is the current level. And given the solid pace of job growth -- an average expansion rate of 174,000 over the last three months -- the Fed will expect further declines in the unemployment rate. Remember, this job growth is well above the rate necessary to keep up with projected labor force growth (65,000 to 115,000) after the demographics take over from the cyclical forces.
A downward revision to the unemployment rate forecast would, all else equal, place upward pressure on rate projections. Sufficient downward revisions would even hold out the possibility that the median dot in the Fed’s assessment of appropriate monetary policy would shift higher another 25 basis points. That would open up a potential fourth rate hike for 2017.
But not all else will be equal. The Fed’s rate forecast also depends on policy makers’ estimates of the natural rate of unemployment, the inflation projection and the neutral interest rate estimate. I assume the last of these is unlikely to change, given the already sharp downward revisions of recent years. That leaves the other factors at play.
Both the Fed’s natural unemployment rate and inflation forecasts look vulnerable at this point. Policy makers have shown a willingness to lower their estimate of the natural rate in the past as persistently tepid wage growth and low inflation suggested previous estimates were too high. But how far are policy makers willing to go? The range of natural rate estimates is currently 4.5 to 5.0 percent with a median of 4.7 percent.
To hold the median interest rate projection steady given an expected decline in the unemployment rate forecast thus most likely means some FOMC participants opening up to the possibility that the non-accelerating inflation rate of unemployment, known as NAIRU, is below 4.5 percent. This would be a fairly dovish shift.
And then there is the inflation forecast. Core inflation took a dive in March, placing the Fed’s current 2017 forecast of 1.9 percent in jeopardy.
A downward revision in the inflation forecast could also offset a downward revision in the unemployment rate forecast, in theory leaving the median rate projection unchanged even if the estimate of the natural unemployment rate remains unchanged.
In my mind, the most important part of this puzzle is the Fed’s estimate of the natural rate of unemployment. If that rate holds constant, policy makers reveal substantial confidence about their estimates of full employment. Moreover, when coupled with a decline in the unemployment forecast, it suggests a concern that diminishing slack in the economy will soon cause overheating and inflationary pressures. This would be fairly hawkish and prod more policy makers to talk about a fourth rate hike this year.
What’s the bottom line for market participants? First, the Fed believes the first quarter GDP weakness was transitory. I suspect that assessment is correct, and that officials will expect fairly solid job growth to continue. This would further justify a decline in the unemployment forecast. Second, watch the inflation data for signs that the March tumble was transitory. This is likely the Fed’s assumption and thus would allow them to hold the rate forecast steady. And finally, be one the lookout for signs that the Fed is rethinking its estimate of the natural rate of unemployment. The strength of their conviction in the 4.5 percent to 5 percent range seems critical at this juncture.
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