The Federal Reserve concluded its March meeting on Wednesday with a widely expected 25 basis-point rate hike and a promise of more to come. The accompanying Summary of Economic Projections also signaled that the Fed expects to overshoot its inflation target. Within the context of the central bank’s framework, policy makers have little choice but to accept some overshooting of inflation. The alternative is a much costlier recession.
With factors including additional fiscal stimulus and a weaker dollar serving as tailwinds for the outlook, the Fed anticipates stronger economic growth compared to projections of last December. Consequently, the unemployment forecast for 2018 fell to 3.8%, a 0.1 percentage-point decline. In addition, central bankers expect another 0.2 percentage-point decline in 2020, to 3.6%.
Importantly, these forecasts compare to a longer-run unemployment rate estimate of 4.5%. Considering the unemployment rate sunk below that level in April, this forecast shows the Fed expects joblessness to remain below the natural rate for well over three years.
This persistent period of low unemployment feeds into the Fed’s forecast and comes out as faster inflation. The projections now show that central bankers expect inflation to surpass the target, rising to a high of 2.1% at the end of 2019.
In other words, the Fed is explicitly forecasting overshooting the inflation target. Policy makers could crank up the interest-rate forecast to eliminate that overshooting but instead have chosen a less aggressive policy path.
If Fed officials were determined to avoid an overshoot, they would need to act more aggressively to push unemployment up toward their estimate of the natural rate. That is a big move in this forecast, a 0.4 percentage point jump from where the rate stands today, and 0.9 percentage point higher than the 2019 forecast.
The Fed, however, has not proven able to nudge up the unemployment rate as much as would be required in this case without causing a recession. Hence, this forecast indicates the central bank is now at the point where policy makers don’t believe they could offset higher inflation without triggering a recession.
That is the right call in this forecast because the costs of an inflation overshoot of a mere 10 basis points outweigh the cost of recession. In addition, this provides an opportunity for the Fed to prove that its 2% inflation target is a symmetric target and that it does not overreact to either small shortfalls or overshoots. Also recall that some central bankers began to worry last year that inflation expectations were drifting downward. A mild overshoot should help stabilize those expectations.
But there is a danger here. The projections imply that the Phillips curve — the tradeoff between inflation and unemployment — is so flat that even a very low unemployment rate has little impact on inflation. This makes the concept of a natural rate of unemployment almost meaningless. How can we take a natural rate estimate of 4.5% seriously if the economy can persistently maintain an unemployment rate of 3.6% without any meaningful increase of inflation? If the Phillips curve is only dormant and not dead, central bankers could find themselves either having to raise rates much more quickly than anticipated or accept greater amounts of inflation overshooting.
The Fed shifted in a hawkish direction as expected. But even with the higher rate projections to balance out stronger growth, there remains a great deal of tension in this forecast. The Fed increasingly relies on a very flat Phillips curve even as unemployment rates head toward levels not seen in five decades. If there is a nonlinearity in the Phillips curve and inflation starts to pick up more aggressively, this bet is going to go sour quickly.
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Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy’s Fed Watch.