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How to read Fed projections like a pro

by SuperiorInvest

Federal Reserve officials on Wednesday released both an interest rate decision and a new set of economic projections, estimates that Wall Street has been eagerly anticipating as it tries to understand what the next phase of the central bank’s fight against runaway inflation will look like.

Officials raised borrowing costs by three-quarters of a percentage point, their third huge increase in a row, bringing their official interest rate to a range of 3 to 3.25 percent. But they also factored in more hikes for the rest of this year and next, projecting rates to reach 4.4 percent by the end of the year and climb to 4.6 percent by the end of 2023.

Here’s how to read the numbers released Wednesday.

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

The dot chart shows the Fed’s 19 policymakers’ estimates of interest rates at the end of 2022, along with a few more years and a longer horizon. Predictions are represented by dots arranged along the vertical scale.

Economists watch closely as the range of estimates shifts because it can signal where policy is headed. Even so, they are most intensely fixated on the middle point (currently 10th). This middle, or middle, official is regularly cited as the clearest estimate of where the central bank sees policy heading.

The Fed is trying to fight back fastest inflation in 40 yearsand officials believe they need to raise interest rates enough to slow spending, curb business investment and expansion and cool a hot labor market. The central bank quickly raised rates, and as inflation remained stubbornly high, expectations of future hikes also rose.

In June, the median official expected interest rates to close the year between 3.25 and 3.5 percent. That has now changed, with a median of officials expecting rates to climb to 4.4 percent by the end of the year and to 4.6 percent in 2023. After that, they expect rates to start falling to 3.9 percent at the end of the year. 2024 and 2.9 percent in 2025.

The most important trick to reading this point plot? Pay attention to where the numbers fall relative to the longer-term median projection. This number is sometimes called the “natural” rate and was most recently 2.5 percent. It represents the theoretical dividing line between loose and restrictive monetary policy.

Here, the Fed is saying that rates will go further into contractionary territory — and that they will stay there until 2025.

Much of Wall Street is fixated on a critical question: Will the Fed accept a much higher unemployment rate in its effort to counter rapid inflation? The second side of the economic projections contains some tentative answers.

The Fed has two jobs. It should achieve maximum employment and stable inflation. Unemployment is very low, employers are hiring voraciously and wages are soaring, so officials think their goal of full employment is more than met. Inflation, on the other hand, is running at more than three times the official target.

Given this, central bankers are now single-mindedly focused on bringing 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 believe is necessary to return to slow and sustained price growth — the really difficult phase of the Fed’s maneuvering begins. Central bankers will have to decide how much unemployment they are willing to tolerate and may have to assess how to balance two conflicting objectives.

Jerome H. Powell, the Fed chairman, has already acknowledged that the adjustment 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 prepared to tolerate.

The new projections have at least strengthened this to some extent. Unemployment increases to 4.4 percent in both 2023 and 2024 from the current 3.7 percent. That’s more than Fed officials previously saw growing.

“That’s the unfortunate cost of reducing inflation,” Mr. Powell said late last month. “However, failure to restore price stability would mean much more pain.”

The road to higher unemployment is paved with slower growth. To force the labor market to cool and inflation to ease, Fed officials believe they must pull economic growth below its potential level — and how much it is expected to fall could send a signal about how punitive the Fed thinks its policy will be.

Many experts believe that an economy is capable of a certain level of growth in any given year based on basic characteristics such as the age of its population and the productivity of its companies. Right now, the Fed estimates that the long-term sustainable level will be about 1.8 percent, adjusted for inflation.

Last year the economy grew much stronger than that – it started to overheat. Now, for inflation to come down, it has to slow below that rate for some time, logical logic. That’s why the Fed sees growth falling to 0.2 percent this year and staying at 1.2 percent next year in its projections: We fired up the economy, and now they think we have to cool it down.

Inflation estimates in the Fed’s projections typically don’t offer much information.

That’s because Fed forecasts predict how the economy will shape up if central bankers set what they consider “appropriate” monetary policy. To be considered “appropriate” by definition, monetary policy must push price growth back toward the Fed’s 2% annual average target over several years. This means that the Fed’s inflation forecasts are always moving back toward the central bank’s target in economic projections.

As it stands, the new forecasts show headline inflation falling back to 2 percent by 2025.

If there is a glimmer of utility here, it is the time it will take for the central bank to return prices to their target level. Fed officials believe that core inflation — a number that strips out food and fuel costs to get a sense of underlying price patterns — will remain at 2.1 percent in 2025.

Result? It will be a long road back to normal, even in an ideal world.

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