The Federal Reserve announced a significant change Thursday in how it manages interest rates by saying it plans to keep rates near zero even after inflation has exceeded the Fed’s 2% target level. (Aug. 27)
The Federal Reserve meets this week amid an economy that has partially rebounded from the punishing COVID-19 recession more swiftly than expected as well as signs that damage from the crisis could linger for years.
It goes without saying the central bank has no plans to raise its key short-term interest rate from near zero, where it’s hovered since Fed officials dramatically slashed it in the depths of the pandemic in March.
But at a two-day meeting that begins Tuesday, the Fed will update its forecasts, providing a roadmap for the course the economy, labor market, inflation and interest rates could take over the next few years. And it could provide clues about just how long rates will stay at rock bottom.
Last month, the Fed unveiled a historic shift, saying it would no longer preemptively raise its benchmark rate as unemployment falls to head off a potential spike in inflation down the road. Rather than aim for 2% annual inflation, the Fed will target consumer price increases that average 2% over time. The Fed’s new policy framework should allow the economy to heat up a bit and underscore that officials are more focused on creating jobs than taming inflation surges.
Such a strategy would make up for inflation that has remained stubbornly below 2% for much of the past decade.
Here’s a rundown of what the Fed is likely to announce Wednesday:
Guidance on interest rates
Economists had expected the Fed this week to revise its guidance for how long its federal funds rate will stay near zero, based on the new policy framework. Now, the Fed’ statement says near-zero rates will prevail until the Fed “is confident that the economy has weathered recent events.”
Goldman Sachs expects the Fed instead to state the rate won’t budge until the economy reaches full employment and inflation is at or above 2% for a period of time. Since very low unemployment will no longer trigger preemptive rate hikes, Barclays expects the guidance to focus solely on inflation.
Both Goldman and Barclays, however, now believe the Fed will alter the guidance late this year rather than this week. Several Fed policymakers have said that, with the course of the virus uncertain, they want to wait until they have a better sense of the economic outlook.
That doesn’t mean rates will rise anytime soon. Oxford Economics doesn’t expect the Fed’s first rate hike until mid-2024 while Goldman is betting on early 2025.
A nod to new policy framework
Goldman expects the Fed to acknowledge its new policy framework by saying that as it considers interest rate changes, it will seek inflation “that averages 2% over time.” The Fed’s statement now refers to its “symmetric 2% objective,” meaning it’s equally concerned about inflation running above or below its goal.
The Fed has been buying $80 billion a month in Treasury bonds and $40 billion in mortgage-backed securities, initially to revive markets for those assets that had frozen amid widespread fears in the early days of the pandemic.
In June, Powell acknowledged the purchases also have stimulated the economy by lowering long-term rates, such as for mortgages. Barclays believes the Fed will more explicitly state the purchases are now intended to spur the economy and bolster that by announcing it will buy bonds with longer-term maturities. Goldman figures the Fed will wait until November to make that change.
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New economic forecasts
The economy has performed somewhat better than expected since the Fed’s last projections in June. Gross domestic product tumbled at a record 31.7% annual rate in the second quarter, a bit better than the initial 32.9% estimate.
And while COVID-19 surges in the South and West led some states to pause or reverse plans to allow shuttered businesses to reopen, hospitalizations and death tolls have improved in some states recently. Goldman expects 30% growth in the third quarter, though that would still leave GDP well short of its pre-pandemic level.
Barclays expects the Fed to upgrade its GDP forecast for all of 2020 to a 4.5% decline from a 6.5% fall in its June estimate. Goldman reckons Fed officials will show a median estimate of a 3.5% drop.
Meanwhile, the nation has recovered slightly fewer than half the 22 million jobs shed in early spring. The unemployment rate fell sharply in August, to 8.4% from 10.2%. Barclays reckons the Fed will forecast unemployment of 7.5% by year-end, up from 9.3% in its prior forecast.
The Fed’s preferred inflation measure also has picked up more quickly lately. The Fed should foresee that measure, which excludes volatile food and energy costs, rising to 1.4% by year-end, up from its prior forecast of 1%, Barclays says.
Wednesday will mark the first time Fed forecasts stretch out to 2023. No surprise: Economists expect officials’ median estimate to show no rate hikes through that period.
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