The Fed has a 'Goldilocks' scenario in mind that will be tough to achieve

The Fed has a 'Goldilocks' scenario in mind that will be tough to achieve
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The Federal Reserve raised rates again this week, taking the policy rate above 2 percent for the first time in a decade. The Fed seems to be on what amounts to autopilot, taking its policy from the super-easy post-financial crisis stance to one that is more normal.

Fed officials peg that "normal," or “neutral,” rate — the interest rate that neither stokes nor dampens economic growth —  at 3 percent, so the Fed probably has at least two or three more hikes to go to achieve that goal.

On its “gradual” track, which has translated into roughly once-a-quarter rate increases over the past two years, the Federal Reserve will get to neutral sometime around the middle of 2019.


The policy rate projections of Fed officials, referred to by financial market participants as “dot” projections because of the way that the Fed reports them, are consistent with getting to neutral sometime in 2019.

Some reports suggest that the Fed is stating that it is already no longer accommodative, based on the fact that the Fed removed a sentence from its post-meeting statement that had stated that “monetary policy remains accommodative.”

But at his press conference, Fed Chairman Jay Powell noted that the dot projections clearly showed that every participant in the meeting pegged the neutral rate setting to be noticeably higher than the current policy setting.

Powell suggested that it was better for the Fed to remove the language, which he said had outlived its usefulness, now, when policy is obviously still accommodative, than to wait until the Fed was approaching neutral, at which point deleting the language would have sparked rampant speculation regarding the future path of rates.

In any case, once we do arrive at a normal, or neutral, policy setting, the Fed’s job is going to get more difficult. In the past, rate cycles typically include a swing from easy policy when the economy is weak to a restrictive stance once the economy gets strong.

The current economic landscape is unambiguously robust, as real economic growth is running more than a full percentage point above the Fed’s assessment of the long-run sustainable pace, and the unemployment rate is near its lowest level since the late 1960s.

Historical experience suggests that the Fed will need to keep raising rates until the economy slows by enough to relieve pressures that almost always develop as the economy overheats.

With the unemployment rate already running close to a full percentage point lower than the Fed’s own assessment of the long-run normal level and monetary policy likely to remain stimulative for at least the better part of a year, it seems more likely than usual that the Fed will ultimately have to push interest rates to a level that will slow the economy significantly to tamp down overheated labor and product markets.

The Fed’s own policy projections offer a very benign scenario. The median projection for the level of policy rates in 2020 and 2021 are only marginally above Fed officials’ estimates of the longer-run neutral rate.

This slightly restrictive policy is expected by policymakers to bring economic growth down to the longer-run sustainable pace, keep the inflation rate steady at 2 percent and push the unemployment rate up in 2021 back toward a more sustainable level.

This "Goldilocks" scenario would be an awfully favorable “ending” to the rate cycle, the mythical “soft landing” that the Fed has rarely been able to achieve. More often than not, once the economy generates the type of momentum that it currently enjoys, it takes a firmer hand from the Fed to take away the proverbial punch bowl.

Thus, the Fed’s official projections represent a best-case scenario that in my view should be viewed as hopeful but not necessarily realistic.

Stephen Stanley is the chief economist for Amherst Pierpont. He is a regular guest on Bloomberg Television, CNBC and is a frequent source for economic articles in the Wall Street Journal.