FOMC Meeting Wrap – September 2023

Yesterday, the Fed decided to keep interest rates steady in a range of 5.25% to 5.50%. However, for a day when the central bank opted not to change the rate at all, the economic projections changed a lot, and in interesting ways.

Fed’s economic projections, available here.

First and foremost, the Fed’s expectation of one more rate hike this year remained unchanged from the previous projection. However, the more significant point of interest for investors was the revelation that the Fed envisions fewer rate cuts in 2024 than previously anticipated, primarily due to the strength of the labor market. This particular piece of information triggered an initial risk-off reaction in the market: it’s not just a question of how high interest rates will climb, but rather how extended their stay at these elevated levels will be. If anything, it’s pretty clear that the FOMC lives in the shadow of the mistakes made in the 70s.

Furthermore, inflation is expected to fall below 3% next year, and to return to the 2% target by 2026. In other words, the new economic projections assume a soft landing. To support this idea, the Fed has doubled this year’s growth estimate and increased 2024 from 1.1% to 1.5% real GDP growth. What’s strange, however, is that the FOMC has also grown far more optimistic about unemployment, cutting its estimate for the jobless rate in both the next two years to 4.1% from 4.5%.

During the subsequent press conference, Powell emphasized the substantial level of uncertainty that policymakers are grappling with. Although such uncertainty might raise concerns, coming from the head of the world’s most influential monetary institution, it actually adds to his credibility: the economy is an intricately complex system, making precise predictions a challenging endeavor for anyone.

The pivotal moment during the Q&A came when Powell was asked to confirm whether a “soft landing” was the Fed’s base case, and he was unequivocal in stating that it wasn’t, regardless of what the economic projections suggested. Although he tried to walk it back later, it became evident that the committee members are not blindly optimistic, but rather genuinely committed to maintain the flexibility to keep interest rates at elevated levels. In other words, the strategy is to operate under the assumption that rate hikes are necessary and to keep them elevated, all while vigilantly monitoring economic data for any signs that justify a shift towards rate cuts.

Finally, a few considerations on the neutral rate. By definition, the neutral rate, denoted as “r*” or “r-star”, represents the interest rate at which monetary policy exerts neither a stimulating nor a restraining influence on economic growth. This concept cannot be directly observed; instead, it must be deducted from how the economy reacts to specific interest rate levels: if the current rates aren’t slowing demand or inflation, then it’s clear that the neutral rate must be higher and monetary policy isn’t tight enough.

Now, turning our attention to economic projections for 2026, we find that the long-term growth rate is anticipated to be 1.8%, unemployment at a stable 4%, and inflation sitting right on the 2% target: these conditions align harmoniously with interest rates at their neutral level. Interestingly, officials also anticipate the FFR to close the year at 2.9%, which implies their belief that the neutral rate has increased.

Of course, it’s important to remember that these projections are just that – predictions. If inflation experiences a gentle descent in the coming year, if economic growth takes an unexpected sharp dip, or if Treasury yields decline, these estimates of the neutral rate may also recede. For the moment, however, the available evidence suggests that the public should prepare for a scenario where interest rates remain elevated for the foreseeable future.