Fed still on hold until 2012 (or later)

As i see it, the Fed is still unlikely to raise the funds rate this year or next – and are only an chance of raising it in 2012 because I think that their economic growth assumptions are not sufficiently aggressive. Certainly, as they see it, they are unlikely to raise the funds rate (or the interest on reserves rates, as the case may be) inside their forecast window.

Most participants again projected that the economy would grow somewhat faster in 2011 and 2012, generating a more pronounced decline in the unemployment rate. In light of stable longer-term inflation expectations and the likely continuation of substantial resource slack, policymakers anticipated that both overall and core inflation would remain subdued through 2012, with measured inflation somewhat below rates that policymakers considered to be consistent over the longer run with the Federal Reserve’s dual mandate

The net effect of the Fed’s April forecast revisions is to marginally put off the date of their first rate hike. The April forecasts are consistent with the Fed funds rate being unchanged at the current 0bps to 25bps through 2012.  Using the Rudebusch (2009) Taylor / Fed-funds formula, it remains the case that optimal policy is to have negative rates through 2012.

The April revisions were for lower CPI across the forecast horizon, and for unemployment to fall a little more quickly in 2010 (ending at 9.3% v. 9.6% in the Jan forecasts), but to end up still very elevated (8.3% v. 8.2% in Q4’11, and unch at 7.05% in Q4’12).

In making these calculations, I followed Rudebusch’s and used CBO estimates of the natural rate (4.8%).   Using the mid-point of the Fed Governor’s estimate of the unemployment rate in the long run – the mid of the central tendency for the ‘longer run’ projection – rather than the CBO estimate increases the optimal rate calculations somewhat, as the Fed governors put the natural rate of unemployment a little higher (5.15% latest estimate).

It should be noted that this mid for the longer natural rate has been creeping higher.  The mid was 5.15% this forecast round, up 5bps from the Jan forecasts.  Those who are arguing that the Fed will hike in 2010 or 2011 because the economy has less slack than the unemployment rate suggests must explain why the Fed Governors agreement with this argument amounts to only a few basis points.

Using the higher natural rate, and their lower CPI forecast, the net change to the Dec’12 optimat rate is -9bps to 0.16% (Q4’12 was 25bps in the Jan projections).

These estimates seem dovish when compared with the average of the street’s economists – but I don’t see that they’ve made the case for their forecasts. Either the Fed’s behaviour has changed – and this case hasn’t been made – or you’re going to need economic outcomes that are A LOT better than the street expects to make their fed funds forecasts correct.

The simple fact is that the Fed is an inflation targetting bank, it does not believe that low rates cause problems (lax regulation is the problem), and it will keep rates low until it gets security that core CPE is going to stick around their estimate of the long run average (1.85%y/y). Core PCE at 1.4% is where core PCE bottomed in 2003 – when the funds rate was 1%, and the unemployment rate peaked at 6.13%.

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