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March 17, 2021

The Fed’s Outlook Has Changed Less Than You May Have Thought

By John L. Bellows, PhD

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FOMC Meeting Recap

A lot has changed since the last time the Fed published its economic forecasts. Last December Covid infections were rising quickly, causing a renewed set of restrictions on mobility and activity, and the prospect of a divided US government weighed on expectations for fiscal policy and future growth. Today, a mere three months later, Covid infections are falling precipitously, vaccines are ramping up and fiscal policy is providing a historically unprecedented boost to incomes over the next few quarters. Given the large magnitude of the changes, it is unsurprising that the Fed’s new economic forecasts, which were published today as part of the Federal Open Market Committee (FOMC) meeting notes, have also changed dramatically. The Fed’s forecast for growth this year increased a full two percentage points to 6.5%; the forecast for inflation increased more than half a percentage point to 2.4%; and the forecast for the unemployment rate was marked down by half a percentage point to 4.5%.

In the face of significant changes in the economic outlook, it was striking that the majority of the FOMC members did not change their forecasts for interest rates in 2023. By leaving the median dot at zero hikes through December 2023, the Fed underscored its decidedly dovish approach to monetary policy. The divergence between the economic outlook, which was marked up sharply, and the monetary policy outlook, which was not changed materially, is a notable development that deserves some explanation.

One reason that the Fed did not change its outlook for monetary policy is that it does not target GDP, nor does it target outcomes for this year. Instead, the Fed’s mandate requires it to focus on labor markets and inflation over the medium term. On both of these fronts there are reasons for the Fed to remain cautious, even as this year’s outlook has improved.

Fed Chair Jerome Powell noted a number of times in his post-meeting press conference that the labor market remains significantly distressed. Many measures of economic activity have now recovered to pre-pandemic levels, and others are very close (GDP is expected to regain its pre-pandemic level by the second quarter). The labor market, in contrast, is a notable laggard. Payroll jobs are still 9.5 million lower than pre-pandemic levels, the prime age participation rate is still 3 percentage points lower and millions of workers report that they have been “permanently” laid off. A full recovery in the labor market is likely to take some time. The process of matching workers to jobs is unavoidably slow. The large sectoral and technological changes that have happened over the past year may make this particular labor market recovery even slower. As long as the labor market remains so far behind the recovery in GDP, investors should expect the Fed to be slow in adjusting monetary policy.

Another important aspect of the Fed’s forecast is that the biggest changes were concentrated this year, and changes to subsequent years were much smaller. This is especially apparent in the forecast for inflation, where the forecasts for 2022 and 2023 were moved up only marginally. There are a number of reasons to expect the rise in inflation this year to be transitory. First, the reopening of the US economy will only happen once. In addition, the significant fiscal stimulus that has just been passed will affect activity for the next few quarters, but it will do much less to affect economic activity next year or thereafter. Further, the headwinds that have pushed inflation down in the past, including technological change, global slack in input markets and elevated debt levels, have not been addressed. These all weigh on Powell’s forecast for inflation and provide a convincing reason for the Fed to look through the current period of elevated price pressures.

The second reason that the Fed did not alter its outlook for monetary policy today is that the recent changes to the Fed’s framework commit it to a very dovish strategy for monetary policy. In particular, the outcome of the Fed’s framework review increased its ambition with regard to both aspects of its dual mandate. Rather than settling for the disappointing inflation outcomes that have defined the last decade, the Fed now aims for inflation “averaging” 2%, which in turn requires inflation to rise above 2% for some time. And rather than settling for labor market outcomes that vary meaningfully across groups, the Fed now aims for a “broad-based and inclusive” labor market strength. To achieve these newly ambitious goals, the Fed must pursue a significantly more dovish policy path.

Chair Powell has not been shy in emphasizing the dovish implications of the Fed’s framework review, and it was a theme that he returned to a number of times today. One key part of that dovish strategy is that the Fed has committed to responding to realized changes in inflation, rather than just changes in the forecast. By focusing on realized inflation, the Fed hopes to avoid the mistakes of the past that have led it to tighten pre-emptively and incorrectly. Moreover, the focus on realized inflation puts the Fed in an inherently skeptical position regarding future bouts of inflation. That is to say that, with regard to inflation, the Fed must see it to believe it. Because inflation over the medium term has definitely not been proven—not to mention the reasons discussed above about why it may not be realized at all—the Fed is therefore unwilling to respond at the moment.

As this discussion suggests, there were likely a number of considerations that went into the Fed’s decision today to leave the monetary policy outlook unchanged, even as the economic outlook was marked up. But, at a high level the message is really quite simple: the near-term upgrade to the economic outlook has less of an implication for Fed policy than you may have thought.

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