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.