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FOMC preview: How optimistic is too optimistic for the US economy?

Brian Cheung · Anchor/Reporter
7 min read

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The Federal Reserve is running into a unique challenge as it kicks off its second policy-setting meeting of the year: maintaining easy monetary policy through what could be the fastest economic recovery in history.

“There’s a lot left to do,” said Fed Chairman Jerome Powell at a Wall Street Journal event on March 4. “We have a lot of ground left to cover and good reason for optimism.”

The Federal Open Market Committee (FOMC) is expected to release its quarterly economic forecasts on where employment and prices are headed over the next three years. Since its last print in December, Congress has passed almost $3 trillion in fiscal stimulus.

As a result, Fed officials are likely to pencil in expectations for greater economic growth, lower unemployment, and a nudge up in inflation compared to previous forecasts.

Dot plots

But the bigger challenge: the Fed’s forecasts on where interest rates are headed. For a central bank that has emphasized it is not “thinking about” raising rates, markets could run away with projections that, for example, signal the possibility of a rate hike in 2022 or 2023.

“If I were [Fed Chairman] Jay Powell, that’s kind of the communications issue I’d be worried about,” said former FOMC staffer Bill English, now a professor in practice at the Yale School of Management.

Markets have already been pricing in the expectation of an earlier Fed hike. The yield on the 10-year U.S. Treasury, a proxy for longer-term interest rates, has surged over 60 basis points since the last FOMC meeting.

As of Monday afternoon, the 10-year yield sat at 1.61%. That pricing implies bond market bets that the Fed will raise rates by the end of 2022.

In its economic projections, the Fed could validate those market bets by pulling forward the timing for an expected rate hike. But the Fed could also hold the line on its December forecast of no rate hike through the end of 2023.

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A "dot plot" chart from the December 16, 2020 FOMC meeting. Released as part of the Fed's Summary of Economic Projections, the dot plot maps out each FOMC member's expectations for where interest rates will go in the near-term. Source: Federal Reserve · Federal Reserve

Deutsche Bank Research expects something in the middle: for the median FOMC member to plot a 25 basis point rate hike by the end of 2023.

“The Fed would still signal that, in their assessment, the market is wrong about the timing of liftoff,” DB Research’s team wrote on March 11.

Inflation expectations

Rising bond yields have nonetheless caught the attention of Fed policymakers, who have largely attributed the market action to rising optimism over the post-pandemic economy.

The question is: Where is the tipping point on inflation?

With the Fed now willing to let inflation rise above its 2% target, the central bank is telegraphing to markets that tighter monetary policy will not be the immediate consequence of signs of price increases.

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