The Federal Reserve will on Wednesday release a new set of economic projections and all eyes will be on two vital questions for monetary policy: will US central bankers signal they expect to start raising interest rates in 2023, instead of 2024? And how high do they expect inflation to rise this year and next?
The Fed will provide clear answers in a table showing, anonymously, all its officials’ forecasts. It has been publishing this data for 14 years under a transparency drive initiated by former chair Ben Bernanke.
The projections can be a useful signalling tool for the central bank, but sometimes they muddle its message. Top Fed officials routinely remind the markets, the media and the public that they should not be used as a guide to policy, which is set in the formal statement from the Federal Open Market Committee — but it can be hard for investors to resist.
Each participant in the FOMC, including the members of the board of governors and the regional Fed presidents, is asked to produce economic projections four times a year, generally in March, June, September and December. Eighteen are expected do so this week.
These are individual forecasts, submitted anonymously, on gross domestic product growth, the unemployment rate, inflation and the level of the Fed’s main interest rate. Participants submit projections for the current year and the next two, and for the long run.
The numbers are then assembled and published at the same time as the FOMC statement. For each indicator, the Fed releases the full range of projections, a central tendency and, most importantly, a median forecast.
The most sensitive forecast by the Fed is its interest rate projection. While the median prediction is published alongside the rest of the economic indicators, it also gets a chart of its own, known as the “dot plot”, which was introduced in 2012. This shows each individual interest rate forecast as a dot, indicating how fast and how big future movements in borrowing costs are expected to be.
During the last Fed projection in March, 11 FOMC officials expected interest rates to remain close to zero at least until the end of 2023, suggesting a tightening of monetary policy in 2024. We will soon find out if that remains the case, or if some FOMC members are now expecting an earlier lift-off. The latter would also imply that the Fed might move earlier to trim its $120bn asset purchases, a precursor to any rate increase.
Jay Powell, Fed chair, once warned that the dot plot has “on occasion been a source of confusion”, and he may be in a no-win situation this week. If there is no change to the median interest rate forecast, the Fed may be judged to be complacent in the face of high inflation. But if central bankers do shift to seeing a rate increase in 2023, it could spook investors by suggesting that the central bank is worried about inflation and might tighten sooner.
The Fed officials’ projections do not often deviate in a big way from those of other economists. After all, they are based on many of the same models. But especially during the pandemic, the central bank has had to make fairly big adjustments to its forecasts.
In March 2020, the Fed did not even bother issuing a set of projections because of the high uncertainty at the height of the lockdowns. “John Kenneth Galbraith famously said that economic forecasting exists to make astrology look respectable,” Powell quipped last year.
Its first virus-affected set of numbers came in June 2020, with the Fed predicting a 6.5 per cent contraction in the economy for the year, with core inflation at 1 per cent and the jobless rate dropping to 9.3 per cent by the end of December. By the end of the year, the picture looked very different, with the Fed expecting the economy to have shrunk by only 2.4 per cent, core inflation forecast at 1.4 per cent, and the jobless rate down to 6.7 per cent.
Now the question is how much better the forecasts will look compared to March 2021, which had the economy growing by 6.5 per cent this year, core inflation at 2.2 per cent at year-end and the unemployment rate falling to 4.5 per cent. It is almost certain that the inflation numbers will show a significant jump, but less so with regard to the growth and labour market data.
Market measures of interest rate expectations point to a slightly earlier lift-off than the Fed’s forecasts from March suggest. One popular proxy — eurodollar futures — indicates the first rate rise will come in the first half of 2023, with at least one more pencilled in later that year. Given the speed of the economic recovery to date, some analysts believe the Fed’s projections could begin aligning more closely with these market metrics.
The market does appear to jive with the Fed’s view that current inflationary pressures will prove “transitory”. Despite US consumer prices rising at the fastest pace since 2008 last month, the yield on the benchmark 10-year Treasury note has fallen back from highs reached in March.
That does not mean markets will not move on the new projections. In fact, the forecasts may be a more important signal than ever, according to investors, given a framework outlined by the Fed last year for how it sets monetary policy.
Rather than pre-emptively raising interest rates to stave off elevated inflation, the central bank has committed to waiting until they see higher consumer prices taking hold. The projections to be published on Wednesday will indicate how officials see that interplay panning out.
“The narrative of monetary policy has changed,” said Pascal Blanqué, chief investment officer at Amundi. “The dots have to be analysed and followed.”
Graphics by Brooke Fox