Beckner: FOMC Opens Door To More Aggressive Tightening As Tax Cuts Loom

14 December, 2017

By Steven K. Beckner

The Federal Open Market Committee's decision to raise the federal funds rate for the third time this year -- the fifth since leaving the zero lower bound two years ago -- was no surprise. The increase to a 1.25% to 1.5% range was once in doubt, but with GDP growing at a 3% clip and labor markets tightening, the Federal Reserve's policymaking body had no trouble fulfilling its start-of-the-year projections for the first time since liftoff, even though two Federal Reserve Bank presidents dissented this time because inflation is still undershooting the 2% target. Of much greater moment is the number of rate hikes 16 FOMC participants, including non-voters, project for next year and beyond. While not huge, alterations to the "dot plot" were significant, though only in the out years. In September, officials' median projection for 2018 was three hikes, taking the funds rate to a 2.0% to 2.25% range -- 2.1% at the midpoint. For 2019, they reduced the number of projected moves from three to two, taking the funds rate to 2.7%. They saw the funds rate hitting 2.9% in 2020 -- a tenth above the longer run "neutral" rate, which was lowered 20 basis points to 2.8%. Now, they still foresee three rate hikes taking the funds rate to 2.1% in 2018 and see it rising to 2.7% in 2019, but have raised their projection for 2020 to 3.1% -- three tenths above neutral. (The projections will be revised March 21st.) After 145 basis points of reduction in six years, the neutral rate was left unchanged; from here it seems more likely to climb than fall, assuming above-potential growth continues. "In the background," balance sheet reduction proceeds apace and will likely continue -- provided there is no "material deterioration in the economic outlook," as the FOMC says. Clearly, the prospect of fiscal stimulus accelerating already faster growth affected officials' calculations, but less so their monetary than their economic projections, at least near-term. Although the 2018 GDP growth forecast was revised up four-tenths to 2.5%, and the unemployment forecast was lowered two-tenths to 3.9%, the funds rate projection for next year was unchanged, though four officials did see the funds rate needing to go a good bit higher than 2.1% next year. Not until 2020 do FOMC participants see the need for more rate hikes than previously anticipated. Janet Yellen, chairing her penultimate FOMC meeting, acknowledged in her final press conference that "most" of her colleagues "factored in the prospect of fiscal stimulus along lines being contemplated by Congress into their projections." And she said they generally concurred that tax cuts would boost the economy though both demand and supply-side effects. Just as clearly, there is great uncertainty about the outlook. The final shape of tax reform and its actual impact is not known. And economic and financial conditions could be affected by non-fiscal forces. As Yellen repeatedly emphasized, "there is considerable uncertainty about the impact (of tax cuts)" and said "it will have to be monitored over time." It might seem surprising that the FOMC did not project higher rates next year, but as Yellen explained, "growth a little stronger and the unemployment rate a little lower might push in the direction of a slighly tighter monetary policy, but counterbalancing that is that inflation has run lower than we expect, and it could take a longer period" of low unemployment to get inflation up to 2%. As events unfold, domestically and internationally, a reconstituted FOMC under new leadership may find it needs to do more or less than now envisioned. But what will matter most, as we step warily into an unknown New Year, is not personnel (Yellen’s designated successor Jerome Powell has basically vowed to continue Yellen's gradual normalization) but the evolution of the economy.