How to read Fed projections like a pro

Federal Reserve officials are set to release both an interest rate decision and a new set of economic projections on Wednesday, and Wall Street is eagerly awaiting those estimates as it tries to understand what the next phase of the bank’s fight will look like. against rapid inflation. .

Officials are expected to raise borrowing costs by three-quarters of a percentage point, their third giant hike in a row, bringing their official interest rate to a range of 3 to 3.25 percent. But investors are hoping the central bank may project an even higher rate by the end of the year, so they will also be looking at the Fed’s first set of economic projections since June to get a sense of what comes next. Here’s how to read the numbers and which ones to watch when they’re released at 2pm on Wednesday.

When the central bank releases its Summary of Economic Projections each quarter, Fed watchers focus obsessively on one part in particular: the so-called dot plot.

The dot plot shows the 19 Fed officials’ estimates for interest rates at the end of 2022, along with longer-term years ahead. The forecasts are represented by points arranged along a vertical scale.

Economists are closely watching how the range of estimates is changing, because it can give a clue as to where policy is headed. Even so, they look more intensely at the midpoint (currently 10). That middle, or median, official is regularly cited as the clearest estimate of where he sees the central bank’s policy heading.

The Fed is trying to fight the fastest inflation in 40 years, and to do that, officials believe they need to raise interest rates enough to curb spending, curb business investment and expansion, and cool a hot job market. . The central bank has been raising rates rapidly, and as inflation has remained stubbornly fast, expectations of future hikes have risen as well.

In June, the average official expected interest rates to close the year between 3.25 and 3.5 percent. It will almost certainly rise with this set of projections: At this point, investors are betting that the rate will rise to a range of 4 to 4.25 percent by the end of the year.

Wall Street will also be keeping a close eye on where and when rates might peak. In June, half of officials expected rates to peak between 3.75 percent and 4 percent or more by the end of 2023. That number could also go up.

The most important trick to reading the dot plot? Pay attention to where the numbers fall in relation to the long-term median projection. That number is sometimes called the “natural” rate, and more recently it stood at 2.5 percent. It represents the theoretical dividing line between expansionary and restrictive monetary policy.

The larger the gap between the expected fed funds rate and the “natural” rate estimate, the more officials expect to clamp down on the economy as they try to dispute price increases.

Much of Wall Street is obsessed with a critical question: Will the Fed accept a much higher unemployment rate in its bid to counter rapid inflation? Page two of the economic projections may contain some preliminary answers.

The Fed has two jobs. It is supposed to achieve maximum employment and stable inflation. Unemployment has been so low, employers are hiring voraciously and wages are skyrocketing that officials believe their goal of full employment is more than met. Inflation, on the other hand, is running at more than three times its official target.

Given that, central bankers are now resolutely focused on getting price gains back under control. But once the labor market slows, unemployment starts to rise and wage growth moderates – a series of events that officials deem necessary to return to slow and steady price gains – the really difficult phase of Fed maneuver. Central bankers will have to decide how much unemployment they are willing to tolerate and may have to judge how to balance two conflicting goals.

Jerome H. Powell, the chairman of the Fed, has already acknowledged that the tightening process is likely to bring “pain” to businesses and households. The Fed’s updated unemployment rate projections will show how much he and his colleagues are willing to tolerate.

The numbers to focus on are projections of the median unemployment rate for 2023, 2024, and 2025. That’s because Fed policy takes time to work its way into the economy, so the maximum consequences will be felt. over time.

In the Fed’s latest set of projections, officials saw unemployment rising to 4.1 percent in 2024. (September is the first set of projections to include 2025.) That was above the current jobless rate of 3.7 percent and higher than the jobless rate of 4 percent. Fed saw as sustainable in the long run.

“These are the unfortunate costs of bringing down inflation,” Powell said late last month. “But failing to restore price stability would mean much greater pain.”

The road to higher unemployment is paved with slower growth. To force the labor market to cool down and inflation to moderate, Fed officials believe they have to drag economic growth below its potential level, and how far it is expected to fall may send a signal about how punishing the Fed thinks it is. It will be your policies.

Many experts think that the economy is capable of a certain level of growth in a given year, based on fundamental characteristics such as the age of its population and the productivity of its companies. Right now, the Federal Reserve estimates that long-term sustainable level to be about 1.8 percent, after adjusting for inflation.

Last year, the economy was growing much stronger than that: it started to overheat. Now, to bring inflation down, it needs to fall below that rate for some time, the logic goes. Based on their latest projections, officials saw 1.7 percent growth this year and next. If they show more of a downward bias this time around, it will be a sign that they believe a more aggressive hit to the economy will be needed to fight downward inflation.

The inflation estimates in the Fed’s projections are typically not very informative.

That’s because the Fed’s forecasts predict how the economy will perform if central bankers set what they consider to be “appropriate” monetary policy. To qualify as “appropriate,” monetary policy, by definition, must push price increases back toward the Federal Reserve’s 2 percent annual average target over the course of a few years. That means the Fed’s inflation forecasts always converge toward the central bank’s target in economic estimates.

If there is a hint of utility here, it is how long the central bank thinks it will take to fight to get prices back to their target level. In June, for example, officials didn’t see it happening until 2024, indicating that the road to more moderate inflation is likely to be a long one.

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