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For months, Jay Powell has tried to dispel hopes of a sudden change in direction by the Federal Reserve at the end of its unprecedented rate hike campaign.
During a press conference on Wednesday, following the Fed’s decision to maintain its 22-year high benchmark rate, Powell emphasized this point. Supported by a new set of economic projections, he made it clear that any easing of high borrowing costs would be gradual and limited.
The projections, which included individual interest rate estimates in a “dot plot,” indicated that after one more rate increase this year, bringing the federal funds rate to between 5.5% and 5.75%, most officials expect a slower pace of rate cuts in 2024 and 2025. Despite the tight monetary policy, they forecasted continued strong economic growth and no significant rise in unemployment.
The forecasts revealed policymakers’ strengthened commitment to a “higher for longer” approach to interest rates. The median estimate from the Fed’s 19 policymakers is for the benchmark rate to decline to only 5% to 5.25% next year. This is significantly higher than the 4.5% to 4.75% projected in the previous dot plot update in June. By 2026, it is still expected to be between 2.75% and 3%.
“What they’re indicating is that if there is stronger growth this year and next, it raises the risk that core inflation will not decline as much as expected,” said Daleep Singh, the former New York Fed official who is now the chief global economist at PGIM Fixed Income.
“Therefore, there may be a need to keep nominal interest rates higher than previously projected,” he added.
Powell’s caution about proceeding “carefully” with future rate decisions, as well as concerns about potential economic headwinds such as a government shutdown and the resumption of student loan repayments, have fueled skepticism.
“The inflation data is likely to surprise them in a positive direction, and I also believe that fourth-quarter growth is likely to be weaker than the third quarter,” said Jan Hatzius, chief economist at Goldman Sachs, who believes that the Fed has finished raising rates.
However, Hatzius is more sympathetic to the idea of prolonged elevated rates. This is supported by an economy that has proved more resilient to higher borrowing costs than expected.
“In general, stronger economic activity necessitates more action with rates,” Powell said when questioned about officials’ prediction of fewer rate cuts next year, despite inflation expectations not worsening compared to June.
Policymakers anticipate that inflation, excluding food and energy prices, will ease to 3.7% by the end of this year before dropping to 2.6% and 2.3% in 2024 and 2025, respectively. In July, the core personal consumption expenditures price index, which measures this inflation, stood at 4.2%.
Furthermore, Powell hinted that a higher-for-longer approach was warranted due to the possibility that estimates of the so-called “neutral” interest rate, which neither accelerates nor decelerates growth, could be higher than previously thought, at least in the short term.
Singh believes the neutral rate could be as high as 3.5%. An increase in the number of workers returning to the labor force and the resolution of other pandemic-related supply chain disruptions could lead to higher productivity and consequently, higher sustainable growth.
Other economists are less optimistic, cautioning that officials’ growth and unemployment forecasts are too optimistic. Policymakers project the economy to expand by 2.1% this year, followed by 1.5% in 2024 and 1.8% in 2025. The unemployment rate is expected to peak at no higher than 4.1% in the next couple of years.
Aditya Bhave, senior US economist at Bank of America, referred to these forecasts as the “most favorable forecasts imaginable,” comparing them to “Goldilocks without the bears.”
Diane Swonk, chief economist at KPMG, expressed both hope and concern, stating, “They have been emboldened by the economy’s simultaneous cooling and strengthening. I hope they are right, but I worry they are wrong.”
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