The Fed’s perception of economic risks continues to evolve, as inflation has moved up to its target more quickly, even as unemployment has declined more rapidly than expected. And the Fed recognizes that the risk of a more substantial rise in inflation has increased. In response, the Fed increased the number of projected rate increases in 2018 from three to four, while retaining a projection for another three rate hikes in 2019. Most importantly, the Fed seems to recognize that policy may have to ratchet rates up more quickly than previously expected.
The Fed’s projections for economic activity were all modified in the direction we anticipated. They reduced their projected 2018 yearend unemployment rate from 3.8% to 3.6%. Since actual unemployment is already at 3.8% (only because it was rounded up from 3.75%), they really had no choice. But did they move their projection enough? Probably not. It is likely, in our judgment, that unemployment will decline below the latest reduced Fed forecast. Job openings now exceed the number of people unemployed, which is unprecedented, so firms are experiencing ever more difficulty in finding suitable workers to hire. In this environment, unemployment could decline to 3.3% or 3.4% before the end of the year, suggesting a dramatically tight labor market.
The projected inflation rate was also revised upward, from 1.9% to 2.1%, a modest change that reflects the latest rise in PCE inflation to 2.0%. It is the longer term projections that were kept flat at the same 2.1% pace that can only be described as mystifying. While inflation has not increased very quickly, despite the growing scarcity of labor, it is hard to imagine that some additional acceleration will fail to occur. PCE inflation was just 1.6% in January. It is hard to fathom why it might now just get stuck at 2.1% for the next couple of years. This projection might be closer to wishful thinking than a real forecast.
Chairman Powell did a fine job of sugarcoating the modest policy change, suggesting it reflected a healthier economy. Yes, the economy is rather healthy, excessively so, so higher interest rates are coming. The Fed is taking the risk that an ever tightening labor market and solid economic growth will not ignite inflation. If inflation were to kick up, the Fed would be forced to tighten policy more quickly than it has projected. In fact, Chairman Powell acknowledged that the committee believes the neutral funds rate is around 2.9%, about a full percentage point above where policy just placed it, suggesting that policy remains accommodative by the Fed’s own judgment. But the Fed clearly prefers to raise rates as slowly as it can.