The FOMC decided to raise the fed funds rate to 0.75% on December 14th, and have pencilled in an extra rate hike in 2017. The media would have us believe that the faster pace of normalising the policy rate to its long term norm now estimated at about 3% reflects both a stronger US economy and expectations of outsized fiscal stimulus under a Trump presidency. An upward revision to Q4 GDP also tends to have some carry-forward into the Q1 level of GDP in the staff’s forecast exercise, thereby explaining the small 2017 revision. That leaves the tiny revision to 2019, which is hardly worth mentioning. At 1.9% that forecast remains at or below the US long term potential growth of about 2%, which in itself is at the high end of the staff’s latest estimate of 1.5% to 2%.
By contrast, the ‘dot plot’ of FOMC participants’ assessment of the appropriate monetary policy has captured the headlines. While it is true that the average level of the policy rate in December calls for three rate hikes of 25 basis points in 2017, instead of the two hikes envisioned at the September meeting, the new outlook still remains less aggressive than what participants envisioned in June, and in the interim most participants seem to have signed on to the latest staff research showing strong evidence that demographics can explain all of the decline in the long term neutral rate of interest rate to less than 1% in real terms (3% in nominal terms if inflation is stable at its target of 2%). A few members remain outliers in calling for the fed funds rate to rise to 3.5% to 4% but that dissenting view is increasingly out of sync with the majority.
If Congress does approve an outsized fiscal package, the staff forecast will be revised upward commensurately with the inescapable consequence of having to raise the inflation forecast for 2018 and beyond. In short, upward surprises in either economic growth or in the nation’s fiscal policy setting are likely to translate into a more aggressive Fed. The December FOMC decision is not yet the clarion call for higher rates at a faster pace, but it is a red flag for things to come if politicians think fiscal policy is a free lunch.