A Macro View: U.S. Federal Reserve – The Path to Normalization
This week, the U.S. Federal Reserve Bank concluded its two-day policy meeting by voting to raise the federal funds target rate by 0.25%, bringing it to a range of 1% to 1.25%. This is the second rate hike this year, and the fourth consecutive hike over the past year and a half. Additionally, the Fed stated that it will begin to normalize the balance sheet later this year, once it is appropriate to do so. The Fed plans to reduce reinvestment in treasuries and mortgage securities by $10 billion a month, and will increase it by $10 billion every three months until it reaches a max of $50 billion.
In light of this week’s decision, it is helpful to review the Fed’s dual mandate that governs the Federal Open Market Committee’s (FOMC) decisions. By law, the Fed is charged with achieving both stable prices and maximum sustainable employment. The FOMC has identified 2% inflation as being most consistent with its price-stability mandate. The sustainable-employment mandate is more complex, as the labor market is affected by many factors. The FOMC employs a moving target, consisting of its participants' estimates of a longer-run normal rate of unemployment consistent with the employment mandate. This week’s Summary of Economic Projections shows the FOMC participants’ median estimate of the longer-run unemployment rate is 4.6%, with unemployment expected to fall to 4.2% to 4.3% for the year, down from the prior projection of 4.5% to 4.6%.
The Fed is more optimistic about the economy, as it expects real GDP to grow 2.1% to 2.2% in 2017, compared to its previous projection of 2.0% to 2.2%. The Fed also forecasts inflation of 1.6% to 1.7% in 2017, below its earlier projections of 1.8% to 1.9%.
Although the market anticipated this rate hike decision, the focus now is on what the Fed will do in the coming months. According to its projected policy path, the Fed plans one more rate hike this year and three more in 2018, bringing the fed funds rate to 2.1%. Despite its best efforts, there is concern that the Fed won’t be able to execute as outlined, due to declining inflation. In May, the year-over-year core inflation, measured by the Consumer Price Index (CPI), slowed for the fourth straight month, to 1.7%. Given this change, there is increased skepticism of an additional rate hike this year.
By many measures, the US economy is late in the business cycle’s expansion phase. The current expansion began in June 2009, and is now eight years in. History suggests that a recession may be looming on the horizon. During previous economic recessions, the Fed needed to reduce the fed funds rate 3% to 4% to stimulate economic growth. The current state of monetary policy implies the Fed would be ill equipped to respond should a recession begin today. For this reason, it is important for the fed funds rate to normalize, giving policy makers room to support the economy during the next contraction. However, the path to normalization must be managed carefully to ensure that the Fed’s changing monetary policy does not cause the next contraction. Fed critics doubt its ability to chart a successful course to normalized rates. Given the current environment of markets and the economy, it’s of little surprise that investors pay such close attention to the Fed.
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