The Fed's Growth Optimism Puts a Floor Under Rates

Officials are more bullish on America's growth prospects, which helps explain why they are somewhat less inclined to lower rates despite more confidence about disinflation.

Federal Reserve officials have been steadily marking up their estimates of how much American workers and businesses can produce since last summer. This has helped put a floor under interest rates despite their increasing optimism (perhaps misplaced) about the inflation outlook. The result is that officials’ estimates of short-term interest rates “under appropriate monetary policy” in the years ahead remain higher than they were when inflation fears were at their peak—and could stay that way.

Growth Bump

Officials’ latest projections of real economic output “under appropriate monetary policy” imply that Gross Domestic Product (GDP) at the end of 2025 will be slightly higher than what had been expected before the pandemic. The projected level of GDP is now more than 3% higher than what had been expected as recently as June 2023.

Yes, officials are no longer as ebullient as they were about America’s prospects in mid-2021, but they have nevertheless managed to reverse much of the pessimistic turn that drove down forecasts of what was possible in the first half of 2022. (Expectations remained depressed from then through mid-2023.)

It is important to remember that these projections are aspirations of what officials want to happen at least as much as they are forecasts of what will happen. Rightly or wrongly, Fed officials believe that there are limits on how much the economy can grow before inflation starts accelerating. The implication is that the longer-term GDP projections are statements about their willingness to let business expand.

The plunge in officials’ growth projections between June 2021 and September 2022 was therefore equivalent to a claim that Americans “needed” to become relatively poorer to get inflation under control. Tellingly, June 2021-September 2022 was also when officials sharply revised up their projections for how much inflation would occur “under appropriate monetary policy”. Officials decided that the non-inflationary limits to growth had become much more constraining, and that they were striking a balance between lower growth and higher prices in response.

The swing in the Fed’s official position since last summer is a reversal from that earlier pessimism.