A Fed Rate Increase Is Expected. But What Comes Next?
Posted December 10, 2017 10:05 p.m. EST
WASHINGTON — The Federal Reserve is expected to end the year by raising its benchmark interest rate for just the fifth time since the financial crisis, as it continues to slowly unwind its post-crisis stimulus campaign. But pressures are building that could prompt the Fed to start moving a little more quickly.
Robust job creation in November is the latest sign of stronger economic growth, and it comes as Republicans are preparing a $1.5 trillion tax cut that President Donald Trump has described as economic “rocket fuel.”
The Fed is widely expected to acknowledge the strength of the economy by increasing its benchmark rate by one quarter of a percentage point on Wednesday, after its final policy meeting of the year. Investors, however, already are looking beyond that decision. They want to know what comes next and whether the Fed, which will soon have a new chairman and several new governors, will deviate from the patient approach of current Fed chairwoman Janet L. Yellen.
The Fed predicted in September that it would increase rates three times in 2018 and two more times in 2019. On Wednesday, the Fed is also scheduled to release a new round of economic projections. Some Wall Street analysts expect stronger growth will push the Fed to add at least one rate increase in each of those years.
“Most FOMC members had not built tax reform into their September projections, and progress has been much more rapid than they (or we) expected,” Seth Carpenter, chief U.S. economist at UBS, wrote in a research note, referring to the Fed’s policymaking arm, the Federal Open Market Committee.
He said the Fed was likely to predict faster growth, less unemployment — and more rate increases.
The pace of increases has broad implications for the economy. The Fed held interest rates at a low level after the financial crisis to stimulate economic growth by encouraging investors to take risks and consumers and businesses to borrow money. By increasing rates, it is reducing those incentives.
The Fed is trying to keep growth at a sustainable pace. It does not want the economy to grow so fast that it drives inflation above 2 percent a year, and it does not want to stall the economy and cause a recession.
The first step is the easy one. The Fed has clearly signaled that it plans to raise rates Wednesday. A measure of investor expectations derived from asset prices put the odds of an increase at 100 percent.
“I think conditions are supportive,” Jerome H. Powell, the Fed governor who is awaiting confirmation as the Fed’s next chairman told the Senate Banking Committee at a hearing last month. Still, Powell said, there must be a vote. “We need to go ahead and have the meeting.”
The future is more difficult to predict. Fed officials already expected the economy to keep growing in 2018, and unemployment to keep falling. But economic reports in recent months have exceeded expectations, including Friday’s estimate by the Commerce Department that employers added 228,000 jobs in November. That has raised the possibility that the economy is continuing to gain strength.
Financial markets have also shrugged off the Fed’s efforts to tighten borrowing conditions. Rates on many loans have declined since the Fed’s most recent rate increase, in June, and credit terms have loosened.
On the other hand, inflation remains oddly sluggish, up just 1.6 percent over the 12 months ending in October. That has prompted a debate among Fed officials. Most, including Yellen, expect inflation and wages to rise as the availability of workers dwindles. But a minority sees no harm in patience.
“Is there really a hurry to raise rates?” Charles Evans, president of the Federal Reserve Bank of Chicago, asked in a recent interview. He said he worried the Fed was undermining expectations that it would take the necessary steps to raise inflation back up to its 2 percent target, which it has undershot for six years. “What if we just decided to wait until the middle of the year and if we saw inflation pick up, then we could do something? I would say at the moment I think the current decision is really a judgment call.”
The pending tax cut is a complicating factor. Monetary policy influences economic conditions gradually. In adjusting interest rates, the Fed must anticipate the evolution of those conditions. It also faces political pressure from Republicans who do not want the benefits of their tax legislation to be offset by faster rate increases. (BEGIN OPTIONAL TRIM.) Powell tiptoed gingerly around tax cut questions at his confirmation hearing. He said that the Fed had not attempted to estimate the impact of the bills passed by the House and the Senate, and that it would not seek to forecast that impact until the legislation became law.
“We will incorporate, when it’s done, fiscal changes that are made,” he said.
The presidents of some of the Fed’s regional reserve banks have offered their own forecasts, generally in line with the consensus among independent economists that tax cuts would be likely to increase both economic growth and inflation by a modest amount in the short term.
Because some Fed officials think the economy is already growing at a pace that is likely to increase inflation over time, they have said that faster growth would not be welcome.
“I’m not in favor of tax stimulus at the current time because the economy doesn’t really need it,” William C. Dudley, president of the Federal Reserve Bank of New York, said late last month.
(END OPTIONAL TRIM.) Economists at Goldman Sachs analyzed the Senate version of the tax cut using the Fed’s economic model and concluded that it would add about 0.25 percentage points to economic growth for a few years, which could cause the Fed to raise rates by an additional half a percentage point above current projections.
Proponents of the tax plan argue that it will deliver a larger increase in economic growth, both in the short term, by increasing spending, and in the long term, by increasing investment.
But Fed officials have expressed skepticism about such forecasts. The government is planning to leave more money in taxpayers’ pockets, and some of that money is likely to be spent. But most economists expect the benefits will be tempered by a large increase in the federal debt, driving up interest rates. The congressional Joint Committee on Taxation estimated in 2014 that every dollar of increased federal borrowing reduced private sector investment by about 15 to 50 cents.
Some proponents of the tax plan argue that interest rates will not rise, increasing the benefit. But Powell at his confirmation hearing indicated that he shared the conventional view.
Regarding the increase in the federal debt, he said, “Either taxes will have to go up to pay for that, or you’ll have even more debt, and that will crowd out private capital and private investment.” (STORY CAN END HERE. OPTIONAL MATERIAL FOLLOWS.) The Fed is unlikely to give a complete account of its thinking on Wednesday.
Fed officials want to avoid taking sides in the final stages of the congressional battle over the tax cuts. The House and Senate are still in the process of reconciling the differences in their tax bills. Yellen, who is expected to step down in February, will hold her final scheduled news conference after the announcement, but she may defer questions about the future to her successor.
“Her comments will likely not be very interesting,” said David Donabedian, chief investment officer of CIBC Atlantic Trust Private Wealth Management. “She certainly does not want to stir the pot.”