The Federal Reserve is expected to lower its economic growth forecast this week, but falling unemployment and rising inflation could prompt policymakers to project a slightly more rapid rise in interest rates.
At a meeting Tuesday and Wednesday, the Fed is widely expected to agree to continue to trim bond purchases aimed at holding down long-term interest rates and spurring growth. The Fed’s policymaking committee is likely to cut the bond buying from $45 billion a month to $35 billion as the economy and labor market continue to improve.
Economists will be more focused on Fed forecasts. In March, policymakers predicted the economy would grow 2.8% to 3% this year. But after it shrank 1% in the first quarter amid harsh winter weather, the International Monetary Fund on Monday downgraded its U.S. Growth forecast for 2014 to just 2% from 2.8%.
Economist Michael Feroli of J.P. Morgan Chase expects the Fed to make a similar adjustment, while Barclays Capital’s Michael Gapen is looking for a more modest drop to 2.5% to 2.7%. Although the weak first quarter will temper growth for the year, the economy is gaining steam after households shed much of the debt they amassed during the mid-2000’s credit boom.
At the same time, unemployment has been falling more rapidly than the Fed anticipated, in part because Baby Boomers are retiring. Feroli expects the Fed to lower its end-of-year jobless rate forecast from the 6.1% to 6.3% range to 5.9% to 6.1%.
Annual inflation, which was disconcertingly low at 1.2% in 2013, is running about 1.6% this year — still below the Fed’s 2% target but a signal the economy is picking up.
Feroli says a forecast for lower unemployment and higher inflation would mean the economy is moving closer to the Fed’s central goals, so would “trump” the weaker economic growth projection. As a result, he says, policymakers likely will predict a slightly more rapid increase in interest rates next year. After keeping its benchmark rate near zero since the 2008 financial crisis, the Fed is expected to start raising it in mid-2015.
In March, bond yields rose and stocks fell after policymakers’ median forecast showed interest rates at 2.25% at the end of 2016, up from 1.75% previously. Gapen says another upward revision likely would push up market rates that have been low on expectations the Fed would raise its benchmark rate slowly.
“The risk is a steepening in the path” of rate hikes, Gapen says.
Further complicating the picture, however, is that this week’s meeting marks a shift in the makeup of the Fed’s policymaking committee. Former Philadelphia Fed executive Loretta Mester recently replaced Sandra Pianalto as Cleveland Fed chief. And Fed Governor Jeremy Stein recently stepped down, while former assistant Treasury Secretary Lael Brainard joined the board. Also joining was Stanley Fischer, who formerly headed Israel’s central bank and will serve as vice chairman.
While Mester is likely more concerned about inflation and eager to raise interest rates, Brainard and Fischer have a more pro-growth approach and are less likely to boost rates quickly, Gapen says. As a result, he says the Fed’s interest rate forecasts could be unchanged.