June 18, 2021
The Fed has finally given us a time schedule for when it might be inclined to raise rates. The Fed’s current forecasts of GDP growth, the unemployment rate, and inflation mean little because the Fed has been far off the mark this past year. But what these latest forecasts do is give us insight into the Fed’s thought process. What will it take to get them to reverse its current wildly stimulative monetary policy?
Economists anxiously await the Fed’s projections for GDP growth, the unemployment rate, and inflation. Because the Federal Reserve system has hundreds of economists it has the manpower to examine issues that the rest of us simply cannot do. But that does not mean it is always right. In fact, the Fed has been farther off base than most private sector economists for the past year. It keeps expecting the worst to happen, but the economic upswing that began in May of last year has been far stronger than anticipated.
For example, in June of last year it thought GDP would decline 6.5% in 2020. In September that got revised to a decline of 3.7%. By December they finally had it about right with a drop of 2.4%. In the end GDP fell 2.5%. In December they thought GDP growth in 2021 would be 4.2%. By March they revised it upwards to 6.5%. And now in June it becomes 7.0%.
The same pattern is true with the unemployment rate. In June of last year the Fed thought it would be 9.3% at yearend. By September it was 7.6%. By December it became 6.7% which is where it ended the year.
Currently the Fed anticipates 2021 GDP growth of 7.0% and believes the unemployment rate should dip to 4.5%. That is not significantly different from our own forecasts which are for 8.0% GDP growth and a yearend unemployment rate of 4.1%. But who knows what will happen? This is a situation we have never seen before. We are all guessing. Will consumers spend most of their excess savings? Will most of the workers missing from the labor force return to work once their federal unemployment benefits disappear? Will the pickup in inflation prove to be temporary or considerably longer-lasting? Time will provide the answer to all of those questions.
So why did the Fed incorporate a couple of rate hikes in 2023? It expects GDP growth of 3.3% in 2022 and 2.4% in 2023. But both of those rates exceed the Fed’s estimate of the economy’s speed limit which is 1.8%. If the economy is at full employment those projected growth rates are likely to push the inflation rate higher. Higher rates might slow the pace of economic activity.
It expects the unemployment rate to end 2022 at 3.8% and then end 2023 at 3.5%. Both of those rates are below the Fed’s estimate of the full employment rate which it believes is 4.0%. The 3.5% unemployment rate is the rate that existed just prior to the recession. Once the unemployment rate has returned to its pre-recession level the Fed will certainly have achieved its full-employment objective.
Finally, it envisions the core PCE inflation measure to rise 3.0% this year, 2.1% in 2022 and 2.1% in 2022. Thus, it believes that the 2021 runup in inflation will prove to be temporary and will essentially return to its 2.0% target level.
From the Fed’s viewpoint this scenario is ideal. The economy is chugs along at a pace roughly in line with its potential. The labor market will have returned to full employment. And inflation will be in excess of its 2.0% target for three consecutive years. It can claim that it has achieved its dual objectives of full employment and an inflation rate slightly above its 2.0% target, and that now it is time to get rates back to a more normal level.
We expect slightly more rapid GDP growth this year and a slightly lower unemployment rate at yearend than does the Fed. But the biggest difference is that we expect the core inflation rate to climb to 4.5% this year and then slow to 3.4% in 2022. If that turns out to be the case, our sense is that the Fed will continue to rely on the argument that the higher-then-expected inflation rate is still attributable to temporary factors and it will choose not to respond. The Fed does not want to be a factor in the elections next November.
Prior to raising its interest rate target, which is a very visible policy response, the Fed has two other policy options.
First, it can raise the interest rate it pays on excess reserves. It paid banks 1.6% just prior to the recession. As the recession got underway It quickly dropped that rate to 0.1%. It increased it marginally last week to 0.15%. This should be viewed as a risk-free rate of return for banks on their excess reserves. As that rate goes higher banks will be less willing to lend their excess reserves to consumers or businesses, which should slow the pace of economic activity.
Second, it can reduce the amount of U.S. government securities and mortgage-backed securities it buys. Currently it purchases $80 billion of Treasury securities each month and $40 billion of mortgages. Thus, it injects $120 billion into the hands of banks every month. Banks can choose to hold those funds as excess reserves in their account at the Fed and get paid 0.15%, or they can lend them to consumers or businesses at a higher rate, but with some inherent risk. If the Fed reduces its monthly purchases, money supply growth should slow as will the pace of economic activity. Thus far, the Fed has given no indication it is prepared to reduce its monthly purchases.
For now the Fed contemplates no near-term adjustments to policy, but given their action this past week we can now better understand what we should be looking for to anticipate such a move.