The Fed's Bullishness Is Pushing Up Rates
The latest projections suggest that the economy has more underlying momentum than previously believed *and* that there is less need to crush the job market to bring inflation back into line by 2026.
We intend to hold policy at a restrictive level until we are confident that inflation is moving down sustainably toward our objective.
—Jerome Powell, September 20 2023
You know “sufficiently restrictive” only when you see it…We want to reach something that we’re confident gets us to that level…and then the question is, how long do you stay at that level? And that’s a whole other set of questions.
—Jerome Powell, September 20 2023
Fed officials now believe that they are (mostly) done raising short-term interest rates. The real question is what happens after that. Will rates stay more or less where they are for the next few years, or will rates revert quickly to something like pre-pandemic norms?
Fed officials are undecided, but they seem to be leaning more and more towards the former view thanks to their growing bullishness about the U.S. economy’s underlying momentum and its resilience thus far in the face of higher borrowing costs. Markets are still discounting something different, although the gap has shrunk since the summer.
The FOMC Moves Towards “Higher for Longer”
Consider officials’ latest projections of where short-term interest rates will be at the end of 2024 “under appropriate monetary policy”. Policymakers have consistently believed that rates should fall in the years ahead as inflation recedes. The current preference is to gradually bring inflation back to 2% a year by the end of 2026, at which point short rates should not need to be any higher than 3%.
But even though many officials have consistently hoped for a downward trajectory in rates from the peak, the expected pace of decline has started to change. In particular, Fed officials now have little confidence that rates will fall much if at all between now and the end of 2024. There is now a plurality of officials (10 out of 19) who believe that rates should be above 5% by the end of 2024, and almost no one who believes that rates will be below 4.5%. If there is going to be a substantial reset lower in rates, it is not projected to happen until 2025-2026. That is a notable change from the prior consensus.
This change in the expected path of interest rates “under appropriate monetary policy” can only be understood in the context of officials’ beliefs about the trajectory for growth, inflation, and unemployment, as well as their beliefs about the impact of changes in interest rates on those other variables.