It is long past time for the Federal Reserve to start raising short-term rates. The unemployment rate is already very close to the Fed's (new, lower) long-term projection of 4.9% and set to fall further in the next year, even if the Fed had already started lifting rates. Nominal GDP growth – real GDP growth plus inflation – is up at a 4.1% annual rate in the past two years, slightly exceeding the Fed's long-run projection of 4% growth.
Regardless, the Fed left short-term rates unchanged at today's meeting and issued, on net, a more dovish statement than after the last meeting in July. Although the Fed acknowledged better business investment, it also provided three reasons for keeping rates unchanged, including (1) lower market-based measures of inflation, (2) global economic developments (which means China-related issues) and (3) financial developments (the recent correction in equity prices).
We don't think any of these factors warranted a longer wait for rate hikes. There's always going to be some excuse to postpone rate hikes. The longer the Fed waits the more likely it is that the US economy eventually requires the kind of aggressive rate hikes that can cause a future recession. Raising rates by 25 basis points today wasn't going to stop anyone from fracking a well or inventing a new App.
In addition to the dovish statement, the Fed slightly marked down its estimates for the long-run average unemployment rate as well as inflation for the next few years. Both of these changes give the Fed more room to temporarily justify keeping rates unchanged.
Consistent with the changes in the economic outlook, the median forecast from the Fed's key decision-makers is that the Fed will only raise rates by 25 basis points this year, versus a prior median forecast of 50 basis points. In addition, the median estimate of the long run average federal funds rate fell to 3.5% from a prior estimate of 3.75%.
The one bright spot in today's statement was that Richmond Fed Bank President Jeffrey Lacker dissented. He would have raised rates by 25 basis points today.
So where does that leave the likely course of monetary policy over the next several months? We believe a rate hike by the end of this year is still likely, but not a slam dunk. The next Fed meeting is in late October. But we see third quarter real GDP growth coming in at about a 2% annual rate. And it's hard to see a Fed so skittish that it didn't raise rates today willing to raise rates in that environment. Instead, December is more likely than October. By that time we should have some indications that real GDP is accelerating in the fourth quarter. However, we also can't completely dismiss the possibility of the Fed waiting until 2016.
The smartest investors know that the starting time for rate hikes is much less important than how high rates will ultimately go. In that sense, today's news was a sideshow and we expect more aggressive rate hikes in 2016 than the Fed and markets now anticipate.
Brian S. Wesbury, Chief Economist
Robert Stein, Dep. Chief Economist
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Posted on Thursday, September 17, 2015 @ 3:29 PM
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