The Federal Reserve significantly raised its expectations for economic growth on Wednesday, but said that rate hikes are not expected through 2023 despite an improved outlook and a turn to higher inflation this year.
As widely expected, the Federal Open Market Committee also voted to keep short-term lending rates near zero while continuing an asset purchase program in which the central bank purchases at least $ 120 billion worth of bonds each month.
The main changes have been in how central bankers see the economic path ahead and what implications this could have for policy.
“Following a slowdown in the pace of recovery, indicators of economic activity and employment have recently emerged, although the sectors hardest hit by the pandemic remain weak. Inflation remains below 2 percent,” the committee said in its meeting statement.
Stocks reacted positively to the news: the Dow Jones Industrial Average rose more than 200 points while longer-term government bond yields remained positive.
According to quarterly economic forecasts by members of the Federal Open Market Committee, gross domestic product is projected to grow 6.5% through 2021 before cooling off in later years. This median estimate represents an improvement over the 4.2% expected increase during the last forecast round in December.
The forecasts for 2022 and 2023 assume growth of 3.3% and 2.2%, respectively, before growth adjusts to a longer-term range of 2.3%.
Together with the increase in GDP, the committee members forecast a decline in unemployment from currently 6.2% to 4.5%. This corresponds to an FOMC estimate of 5% in December. The forecasts for the next two years are 4.2% and 3.7% before reaching a longer-term level of 4%.
Core inflation expectations rose and the Committee is now targeting a 2.2% increase this year as measured by personal consumption expenditure. It is estimated that this figure will decrease to 2% in 2022 and increase to 2.1% in the following year, with a long-term expectation of 2%.
In terms of how these improvements will affect policy, the Committee continues to expect policy rates to remain unchanged through 2023.
Fed chairman Jerome Powell said he expected inflation to rise this year, partly due to poor year-on-year comparisons from the early days of the Covid-19 pandemic in early 2020. However, he said that will not be enough to change a policy that seeks inflation above 2% for a period of time if it helps achieve full and inclusive employment.
“I’d like to point out that a temporary rise in inflation above 2%, as is likely to happen this year, would not meet that standard,” Powell said.
Other members see wanderings ahead of them
Members’ expectations for interest rates were a bit hawkish, but not enough to change the forecast.
Four of the 18 FOMC members were looking for a rate hike in 2022, compared to just one at the December meeting, according to the “scatter chart” of each member’s forecast. Seven members are seeing a hike in 2023, compared to five in December.
Markets watched the forecasts closely, expecting the Fed to react to the recent boom in economic growth and expectations of higher inflation. Market-based inflation measures point to a rate of 2.59% in five years, the highest level of the “break-even” rate in nearly 13 years.
However, the post-meeting Fed statement continued to suggest that policy will remain loose until “substantial further progress” is made towards its dual goals of full employment and price stability.
In 2020, the Fed changed these targets so that policies would remain accommodative until employment not only increased significantly, but also in such a way that benefits were distributed across income, race and gender. Consistent with this goal is a willingness to let inflation stay slightly above the Fed’s 2% target for an indefinite period in order to meet the employment target.
Markets have been surging lately on fears that inflationary pressures could pose a greater threat than the Fed thinks.
Government bond yields have risen to levels last seen before the Covid-19 pandemic as investors worry that inflation is eroding the capital of their fixed income holdings. Inflation is bad for bonds as future interest payments are worth less for holding the bonds. Rising yields mean falling prices that occur when holders sell their bonds.
However, the Fed is happy with some increase in yields as long as they do it in response to economic growth. The Fed regards 2% inflation as a healthy level of the economy, while at the same time giving the central bank leeway for policy action. Should inflation spiral out of control, Fed officials believe they have the means to control it.
Over the past few weeks there has been some market expectation that the committee might adjust the asset purchase program to buy more long-term bonds to keep interest rates lower, but there was no suggestion in Wednesday’s decision.