Federal Reserve officials expect to start raising interest rates in 2023, earlier than previously forecast, according to new economic projections that predicted faster growth and sharply higher inflation this year.
At the end of its two-day policy meeting on Wednesday, the US central bank kept its main interest rate on hold at the rock-bottom range of 0 to 0.25 per cent, where it has been since the start of the pandemic.
But whereas in March, when most Fed officials predicted that current rates would be maintained until at least 2024, the consensus has shifted towards an earlier lift-off in 2023, signalling the central bank’s belief in a faster transition to a full recovery and tighter monetary policy. The Fed’s projections indicate at least two rate increases are expected in 2023.
At a press conference on Wednesday, Fed chair Jay Powell struck an optimistic tone about the pace of job creation, despite some near-term weakness, especially as Covid-19 vaccinations increase and lockdown measures ease.
“There’s every reason to think that we’ll be in a labour market with very attractive numbers, with low unemployment, high participation and rising wages across the spectrum,” he said.
Powell also stressed that there was a risk that inflation could be higher than predicted, but emphasised that the central bank had the tools to address it if needed.
The median of Fed officials’ estimates now forecasts gross domestic product growth of 7 per cent this year, compared to 6.5 per cent in March, with the unemployment rate dropping to 4.5 per cent, in line with earlier predictions. Core inflation is expected to be 3 per cent this year, sharply higher than the 2.2 per cent expected in March, before falling back to 2.1 per cent in 2022.
Powell’s outlook aligned closely with the one laid out in the Federal Open Market Committee’s statement released on Wednesday. “Progress on vaccinations has reduced the spread of Covid-19 in the United States,” it said. “Amid this progress and strong policy support, indicators of economic activity and employment have strengthened. The sectors most adversely affected by the pandemic remain weak but have shown improvement.”
The FOMC on Wednesday kept its asset purchases steady at $120bn per month — another feature of the exceptionally loose monetary policy introduced to fight the economic fallout from the pandemic. Officials are expected to have held initial talks on the timing and conditions of an eventual move to start reducing those bond buys, but the statement made no mention of a shift.
The process of reducing the Fed’s debt purchases, known as “tapering”, could be discussed for months before a move is made. The Fed has said the economy would have to make “substantial further progress” compared to last December in order for to start scaling back its extraordinary support for the economy.
Powell said at the press conference that the process of winding down the asset purchase programme would be “orderly, methodical and transparent”, underscoring that any adjustment would be communicated “well in advance”.
While inflation has been moving above the Fed’s target of 2 per cent on average, its full employment goal has not been met. Some 7.6m fewer Americans hold jobs than in February 2020.
The Fed has stressed that its monetary policy guidance is not calendar-based but dependent on economic outcomes. Specifically, it said it would only raise interest rates if the economy is at full employment with inflation at 2 per cent and on track to exceed that level for some time. Nevertheless, while seven out of 18 FOMC members predicted in March a first interest rate increase in 2023, 13 did so on Wednesday.
Powell said the dot plot should be taken with a “big grain of salt”, given that it reflected individual projections as opposed to a FOMC forecast.
Since the last meeting of the FOMC in April, US equity markets have rallied, while borrowing costs have dropped from recent highs, as investors wagered that the Fed will keep its monetary stimulus going and this year’s inflationary pressures will be transitory.
US government bonds sold off sharply after the Fed announcement, with the yield on five-year Treasuries jumping over 0.12 percentage points to 0.895 per cent.
The more policy-sensitive two-year note traded 0.04 percentage points higher at 0.21 per cent, while the benchmark 10-year note lept more than 0.08 percentage points to 1.577 per cent. That is below the recent highs seen in March, but elevated from earlier in the week. Yields rise as prices fall.
The Fed also announced on Wednesday that it would adjust two technical rates, including the rate it pays banks on excess reserves they hold at the central bank. It raised the so-called IOER rate to 0.15 per cent, from 0.10 per cent. It also agreed to pay more than zero on the reverse repurchase programme, boosting the rate to 0.05 per cent.
Eligible money market funds and banks have clamoured to stash money overnight at the Fed as they have few viable, positive-yielding places to invest the enormous amounts of cash that has bolstered their coffers since the start of the year. The Fed said in a statement that the adjustments were aimed at supporting “the smooth functioning of short-term funding markets”.