On the evening of Friday 24 July, the Fed disclosed that the staff projections it uses for monetary policy committee (FOMC) meetings, which are supposed to remain confidential, had been accidentally posted to its website at the end of June. Normally, these projections are released to the public after a five-year lag. The incident seems to be the result of an inadvertent mistake, and it is currently being investigated. However, once the information was released to the public, the Fed had no choice but to leave the projections on its website, where they are available to all (see table).
Just before the FOMC meeting on 29 July, several questions must be asked:
- Even if FOMC members do not necessarily agree with these internal projections, they clearly take them into very close consideration.
- As for key interest rates, the staff's central scenario is for the fed funds rate to increase by 35 bp in 2015. In concrete terms, this means that the rate increase cycle is supposed to begin in September or December. Finally, the staff has forecast an increase of around 100 bp in 2016 and in 2017. This is no surprise: the promised "gradualism" of monetary policy means that interest rates will be hiked every other FOMC meeting (or by 100 bp per year).
- As for long-term interest rates, the Fed's staff expects them to rise more abruptly than we do, with 10-year Treasuries yielding more than 3% by end-2016. Reading between the lines, this means that, as long as it is gradual, an approximately 80 bp rise in long-term interest rates (the 10-year bond yield is currently 2.25%) would not induce the Fed to stop its cycle of increasing interest rates (inasmuch as its impact has already been factored into their projections).
- According to Fed staff, the output gap (OG) should be close to zero as of 2016 and would be closed sometime in 2017. In other words, output should return to its potential by that time. In contrast, in our central scenario, we had not expected – until recently – the output gap to close before 2019. Our projected output gap is at approximately -1.6% by end-2015 (vs. -1% for the Fed). This is a significant difference, particularly since Fed staff estimates potential growth at 1.7% in 2016-2017 and 1.8% in 2018. This falls well short of the estimates made by the CBO (2.1% for 2016-17 and 2.2% for 2018), whose methodology is the benchmark in the US and which we have used in our own calculations. Fed staff estimates potential growth in 2019 to stand at 1.8%, while the CBO expects it to be 2.3% (the figures for 2019 are 1.8% vs. 2.2%). A difference of half a point each year between two measurements of potential growth is not without consequences.
- The Fed's staff is probably confirming that the marked slowdown in productivity gains (an average of less than 1% annually for the last five years) is primarily structural.
How does this affect monetary policy?
All else being equal (i.e., especially if the Chinese economy does not take a swan dive big enough to weaken Asia and the global economy), closing the output gap is an argument in favour of starting to raise interest rates quickly.
- Of course, the staff expects core inflation to remain below 2% for another five years. However, it could be argued that it is precisely the gradual increase in real interest rates (short- and long-term) that would contain inflation over this period. If the slowdown in productivity is structural and wages rise faster (unemployment is reaching its equilibrium level), then unit labour costs (which are already growing at a pace that matches the average of the last 30 years) could rise more significantly. To the extent that this is the main determining factor for core inflation, the inevitable result, after a delay of some months, would be the first upward pressure on prices (from an admittedly very low level).
- In addition, the terminal fed funds rate is close to what surveys indicate (3.3%) . That said, at the end of 2018, the fed funds rates would remain below this level (at 2.8%), which clearly demonstrates the Fed’s commitment to gradualism.
- Naturally, none of this should be taken at face value. These are "only" internal projections. In the past, the Fed staff has been just as mistaken, on average, as other forecasters (moreover, it was Fed researchers who demonstrated this).
- Staff projections nevertheless provide a clear picture of the underlying scenario on which monetary policy decisions are based. We have a better understanding of the Fed's determination to start raising rates. The only thing that could cause it to postpone such an action would be a marked deterioration of the global situation.
1. The output gap (OG) measures the difference between actual GDP and potential GDP (the gap is expressed as a percentage of potential GDP).
2. The potential output is the maximum amount of goods and services an economy can turn out when it is at full capacity, i.e. without inflation.
3. A survey of 50 economists conducted by Bloomberg between 20-22 July predicted the terminal fed funds rate to be around 3.3%.