Federal Reserve officials will release interest rate decisions and a new set of economic forecasts on Wednesday to get an idea of what the next phase of the central bank’s battle against rapid inflation will look like. It is estimated that Wall Street has been waiting for this.
The authorities raised the cost of borrowing by three-quarters of a percentage point, the third consecutive jumbo rise, and cut the official interest rate to a range of 3-3.25%. But they also plan additional hikes for this year and the remainder of next year, with interest rates projected to reach 4.4% by the end of the year and rise to 4.6% by the end of 2023.
Here’s how to read the numbers released on Wednesday:
Decoded dot plot
When Central Banks Release It Summary of Economic Forecasts Every quarter, Fed watchers are obsessed with one part in particular: the so-called dot plot.
The dot plot shows the 19 Federal Reserve policymakers’ estimates of interest rates at the end of 2022, as well as their estimates for the next few years and over the longer term. Forecasts are represented by dots placed along a vertical scale.
Economists are watching closely how the range of forecasts is changing. Still, they’re most focused on the middle dot (now his 10th). This middle or median official is regularly cited as the clearest estimate of where the central bank sees policy direction.
The Fed is trying to contain the fastest inflation in 40 years. To do that, officials believe, it will be necessary to curb spending, curb corporate investment and expansion, and raise interest rates just enough to cool the overheated job market. Central banks are raising interest rates rapidly, and with inflation remaining stubbornly rapid, expectations for future increases are also rising.
In June, median officials expected rates to end the year between 3.25% and 3.5%. That’s changing now, with median officials expecting rates to rise to 4.4% by the end of the year, and by 2023 he expects them to rise to 4.6%. 2.9% in 2024 and 2025.
The most important trick for reading this dot plot? Notice where the numbers are compared to the long term median forecast. This figure is sometimes referred to as the “natural” rate and was recently 2.5%. This represents the theoretical boundary between accommodative and restrictive monetary policy.
What the Fed is saying here is that interest rates will enter even more restrictive territory and will remain so until 2025.
Unemployment projections are key
Most of Wall Street is fixated on this key question: Will the Fed accept much higher unemployment to counter rapid inflation? The second page of economic forecasts contains some preliminary answers.
The Fed has two jobs. It is supposed to achieve maximum employment and stable inflation. With unemployment very low, employers actively hiring, and wages trending upward, officials believe the full employment target has been well met. Meanwhile, inflation is more than three times his official target.
Given that, central banks are now single-mindedly focused on getting inflation back under control. But as the job market slows, unemployment begins to rise and wage growth slows, officials believe it will take a series of events to return to moderate and steady inflation. The central bank will have to decide how much unemployment it can tolerate, and he may have to decide how to balance the two conflicting goals.
Fed Chairman Jerome H. Powell has already admitted that the adjustment process is likely to bring “pain” to businesses and households. The Federal Reserve’s latest unemployment forecast shows how much he and his colleagues are ready to tolerate.
New predictions have strengthened it, at least to some extent. The unemployment rate is expected to rise from 3.7% in 2023 and 4.4% in 2024. That’s higher than Fed officials have seen before.
“These are the unfortunate costs of keeping inflation under control,” Mr. Powell said late last month. “But failure to restore price stability would mean far greater pain.”
See growth outlook
The road to higher unemployment is paved by slowing growth. Fed officials believe that to cool the job market and keep inflation under control, economic growth must fall below potential levels.
Many experts believe that an economy is capable of a certain level of growth in any given year, based on fundamental characteristics such as the age of the population and the productivity of firms. The Fed currently estimates a long-term sustainable level of about 1.8%, adjusted for inflation.
Last year, the economy grew much stronger than that and started to overheat. Now, the logic is that in order for inflation to go down, it needs to slow below that rate for some time. As such, the Fed expects growth to drop to 0.2% this year and stay at 1.2% next year.
Pro Tip: Ignore Inflation Estimates
Inflation projections in the Federal Reserve’s projections don’t usually provide much insight.
This is because the Fed’s projections predict how the economy will shape if the central bank sets “appropriate” monetary policy. By definition, to be considered “adequate,” monetary policy must push inflation back toward the Fed’s average annual target of 2% over several years. In other words, the Fed’s inflation forecast always converges towards the central bank’s economic forecast target.
New projections show headline inflation falling to 2% by 2025.
If there is a small utility here, it is how long the central bank thinks it will take prices to return to their target levels. Fed officials expect core inflation—the number that excludes food and fuel costs to capture underlying price patterns—to stay at 2.1% in 2025.
Result is? Even in an ideal world, we have a long way to go to get back to normal.