Fed Would Surprise Markets If It Stays Hawkish

The Federal Reserve meeting this week will likely end with unchanged policy rates and the initiation of balance-sheet normalization. Market participants widely expect these outcomes, so they will come as no surprise. The real action in this meeting will come from the Fed’s description of the economy, the quarterly economic projections and Chair Janet Yellen’s press conference. The totality of the commentary should lean dovish as the Fed expresses concerns about the inflation outlook. The surprise would be a Fed that still leans more heavily toward the hawkish side of policy spectrum.

Consider the Fed’s economic projections (median of central tendency) from June in comparison with the latest values:

Indicators (%), latest values in italics




Longer Run

Change in real GDP

  First half 2017: 2.1%





Unemployment rate

  August 2017: 4.4%





PCE inflation

 July 2017: 1.4%





Core PCE inflation

 July 2017: 1.4%





Federal funds rate

  Current target: 1.0-1.25%





In general, policy makers retain an optimistic outlook on economic growth. The second-quarter GDP rebound brings first-half average growth in line with the Fed’s full-year expectations. Central bankers will likely call attention to solid consumer spending and firming business investment in the post-meeting statement, while retaining the GDP forecast for the full year. They may also bring attention to some disruption in the data due to recent hurricane activity, but will view any impacts as temporary.

I continue to believe that ongoing growth above the longer-run estimate of 1.8 percent places the Fed’s unemployment forecast at risk. Nonetheless, the unemployment rate remains stuck at 4.3 percent to 4.4 percent, a range entered this past spring. Hence, policy makers have reason to hold the forecast or make only a small downward revision.

Then comes inflation, the sticking point for central bankers looking to retain the Fed’s June rate projections. The central bank’s preferred inflation indicator stubbornly refuses to cooperate with earlier Fed forecasts of a nearly target rate by the end of this year:

To be sure, CPI numbers for August likely buoyed the hopes of inflation optimists on the FOMC:

The boost, however, stemmed from a gain in shelter costs, which are less prominent in the PCE inflation measure (and possibly only temporary). Hence this single CPI report gives only limited support to those hoping that PCE inflation makes a strong course reversal later this year.

Given the magnitude of the inflation weakness, it seems inevitable that the 2017 inflation projections undergo a downward revision. Moreover, persistently low inflation and soft wage growth would more likely than not induce policy makers to lower their estimates of longer-run unemployment. Both revisions would place downward pressure on rate projections for this year, assuming the Fed remains true to its reaction function.

Consequently, expect the 2017 rate projection “dots” to shift lower as those expecting two more rate hikes as of last June largely abandon that position, while some who were expecting just one more rate hike make a similar adjustment. The median expectation of one more hike will likely hold; many Open Market Committee participants believe the inflation decline reflects transitory factors and hence will be hesitant to eliminate their expectation of another rate hike this year even if they accept a lower inflation forecast.

I suspect that inflation weakness will induce the most optimistic Fed participants to pare their 2017 and 2018 rate forecasts, lowering the top-most dots. That would be dovish in and of itself. But more dovish would be a more general downward shift that brings down the median rate forecast. I am wary of anticipating such an outcome as it likely requires a larger number of Fed participants to embrace the view that the inflation weakness is less about transitory factors and more about persistence stemming from declining inflation expectations, a viewpoint championed recently by Federal Reserve Governor Lael Brainard. That said, the risk is clearly in that direction.

My expectation is that Yellen will reassert the dominant view at the Fed: The Phillips curve will eventually gain traction and push inflation back to target. Still, the Fed chair will acknowledge that inflation weakness had been more persistent than expected, raising questions about the reasons for that persistence. She will reiterate policy remains data-dependent and hence no decisions have been made regarding the outcome of the December meeting. Watch for signals that Brainard’s concerns about inflation expectations are gaining traction within the FOMC. I don’t think this is the case yet, but would be a dovish signal if I am wrong. I expect that a reporter will press Yellen on this topic.

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