The US Federal Reserve (Fed) has bitten the bullet: At their policy-making meeting on Dec 14 and 15 — in recognition of persistent high inflation — officials will announce a speedier tapering of asset purchases that have been supporting economic growth. The aim is now to complete the programme in time to be able to start raising short-term interest rates as soon as March should that prove necessary.
But the taper is not all that will be on the agenda at the meeting. Fed officials are also likely to signal a faster and larger tightening of monetary policy over the next three years — to an extent that markets have not yet anticipated.
The last time the Fed published officials’ economic projections — in September — the outlook was remarkably benign. They expected inflation to fall back close to the Fed’s 2% target, even as employment pushed past the level consistent with price stability. And they thought this pleasant outcome would require very little Fed intervention: Their median projection for the central bank’s short-term target rate at the end of 2024 was 1.8%, well below the 2.5% level most judged as neutral.
This time around, the broad contours of the economic outlook will probably be similar. The median forecast for next year will show above-trend growth pushing unemployment below the 4% level considered sustainable in the long run. Inflation will fall from current high levels, though not as much as previously projected, resulting in a larger and more persistent miss over the Fed’s 2% objective.
The biggest change will be in the interest-rate policy officials deem necessary to achieve that economic outcome. Last time, the median projection for the Fed’s short-term interest rate target at year end was 0.3% for 2022, 1% for 2023 and 1.8% for 2024. This time, the upward path will start sooner, be steeper, and rise higher.
For 2022, I expect a median forecast of 0.8%. This would signal three 0.25-percentage-point increases next year — not so many as to require a rate hike in March, but enough to be consistent with the faster taper and the unemployment and inflation outlook. For 2023, I expect officials to project four more rate hikes, taking the median target rate to 1.8% a year earlier than in the September projections. Such gradual, consistent tightening makes sense once the Fed gets started. But policymakers are not likely to anticipate moving more quickly as long as they project inflation to remain below 2.5%.
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For 2024, I expect the projected target rate to reach the 2.5% level judged as neutral. Anything less seems hard to justify, given that the economy will have been running beyond full employment and above the Fed’s 2% inflation target for several years. One could make the case that the 2024 interest-rate projections should go beyond neutral, signalling greater resolve to keep inflation in check. But I doubt officials will have the stomach for that, given the uncertainties surrounding any longterm economic forecast, made even more complicated by the constantly evolving Covid-19 pandemic.
The shift in the Fed’s interest-rate projections might come as a shock to markets. Futures prices suggest that investors are expecting two or three 0.25-percentage-point rate hikes in 2022. But the total magnitude of tightening has not increased: Eurodollar futures imply a peak in the federal funds rate of around 1.5%. That is well below the levels projected by every member of the Federal Open Market Committee, and well below what common sense would dictate. The Fed’s operating framework, actions and projections all suggest that monetary policy will remain accommodative long after employment and inflation have exceeded the central bank’s objectives. It follows that interest rates will eventually have to go higher to compensate.
A faster taper should be welcome news: It gives the Fed more room for manoeuvre, opening up the possibility of earlier rate hikes if they are needed. But it may entail a difficult adjustment for markets.
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At some point, investors will have to revise their interest-rate expectations significantly, potentially triggering a market tantrum. And the longer this adjustment is delayed, the greater the tantrum is likely to be. — Bloomberg Opinion
Cover photo: Bloomberg