What's Worrying The Fed?

To no one’s surprise, the Federal Reserve has opted to increase interest rates for the third time this year, by a quarter-point to a target range of 2% to 2.25%.

The market might as well yawned. There was little change to Treasury yields, Heidi Learner, chief economist at Savills Studley, noted with the 2-year yields remaining around 2.83% and 10-year yields holding between 3.06% and 3.08%.

Fed Chair Jerome Powell put the increase in perspective during a press conference. “Our economy is strong,” he told reporters. “These rates remain low, and my colleagues and I believe that this gradual returning to normal is helping to sustain this strong economy.”

Better Growth Expectations

Indeed the Fed raised its expectation for economic growth to 3.1% from 2.8% for 2018. Next year Fed officials forecast growth will slow to 2.5%, an upward revision from the 2.4% that they had projected last quarter. Expectations for inflation were unchanged, with core PCE price index and PCE inflation projected to end 2018, 2019, 2020 and 2021 between 2% and 2.1%–exactly in line with the Fed’s longer-run forecast for PCE, Learner said. Finally, the Fed also indicated, again, that more rate hikes were likely coming this year and next.

Much of this is business as usual; if nothing else the Fed does a good job of signaling to the market its intentions. However, there was one surprise from the policy-makers on Wednesday, according to Heidi Learner, chief economist at Savills Studley: their forecasts for 2021. In their June projections, the Fed’s forecasts extended only through 2020, she said.

Concerns About Inflation

“The Federal Open Market Committee appears to be forecasting the perfect ‘soft landing’ by 2021, yet appears concerned enough about inflation than they anticipate another five rate increases over the next nine quarters,” Learner writes in a research note. Her question: Is the Federal Reserve worried about the impact on inflation from tariffs and fiscal policy changes?

In his press conference, Powell said there was a “rising chorus” of concerns about the US-China trade war. But he added that the economic impact of US tariffs is “still relatively small.” The tariffs could lead to higher consumer prices, but policymakers haven’t seen that in the numbers yet, he also said.

So why has FOMC penciled in an additional 25 basis points of tightening in 2018, 75 basis points of additional tightening in 2019, and a further 25 basis points in 2020? Learner questions. The answer is plain to her: “Because policy rates are still accommodative, even though today’s FOMC statement explicitly removed the phrase “the stance of monetary policy remains accommodative”—a phrase that had been included in the FOMC statement as recently as last month,” she wrote.

Learner’s conclusion is that the Fed is more worried about inflation than it suggests. “Something doesn’t sit quite right,” she writes. “GDP growth, while running above trend, is scheduled to fall back to its longer-run rate by 2021, even as inflation is not expected to accelerate beyond the Fed’s target. With no acceleration in inflation, why do we need five additional rate hikes?”