No September Surprise: U.S. Economic Strength Prompts Fed to Raise Policy Rate

The Federal Reserve’s September statement, projections and press conference were in line with our expectations and support our view that the Fed will continue on a gradual trajectory of interest rate hikes. PIMCO forecasts three additional policy rate hikes by the end of 2019, and we expect the Fed to continue to run down its balance sheet before announcing a change to balance sheet policy as early as the fourth quarter of next year.

In the new Statement of Economic Projections, participants revised higher their 2018 GDP growth forecasts in response to the robust readings on current economic activity since June, and the new rate path forecasts (the “dot plot”) illustrated a strong committee consensus for another rate hike in December.

As was widely expected, today the Federal Open Market Committee (FOMC) announced another increase in the federal funds rate target range to 2.0%–2.25%, marking the eighth rate hike of this cycle. Notably absent in the statement was the (by now familiar) language, “The stance of monetary policy remains accommodative,” though Chairman Jerome Powell was careful to emphasize during his press conference that this does not signal a change to the outlook for rate hikes.

During the press conference, Chairman Powell reiterated the FOMC’s need to balance the risks of moving too quickly and snuffing out the recovery with moving too slowly and risking the economy overheats. A few times, Powell mentioned long and variable lags of monetary policy, and the uncertainty around estimates for the level of the longer-run neutral rate. He repeated that central bankers don’t see many signs of overheating, and believes a continued gradual pace of rate hikes will allow central bankers time to assess how the economy is reacting to the cumulative increase in interest rates to date.

Medium-term outlook unchanged

However, regarding the medium-term outlook for interest rates, the committee provided markets with little news. The median expectation for the fed funds rate in 2019 and 2020 was unchanged relative to the June projection. Most FOMC participants continued to project the need for modestly restrictive policy due to strength in labor markets, fiscal policy stimulus and what many FOMC participants characterize as still favorable financial conditions. The median projection for the longer-run fed funds rate inched higher by 0.1 percentage points. However, the addition of Vice Chairman Rich Clarida’s projection (and the removal of former New York Fed President Bill Dudley’s) makes it difficult to ascertain whether the small tick higher was the result of a change in any individual participant estimates or a shift in the individuals included in the sample.

In deciding what to do with interest rates, though, the Fed is acting exactly as it should, providing much-needed competence and consistency at a time when those qualities seem in short supply.