How to read the Fed’s projections like a pro
By Jeanna Smialek
Federal Reserve officials released both an interest-rate decision and a fresh set of economic projections on Wednesday, estimates that Wall Street was keenly awaiting as it tries to understand what the next phase of the central bank’s fight against rapid inflation will look like.
Officials raised borrowing costs by three-quarters of a percentage point, their third-straight jumbo increase, taking their official interest rate to a range of 3% to 3.25%. But they also penciled in additional increases for the rest of this year and next, projecting that rates would reach 4.4% by the end of the year and climb to 4.6% by the end of 2023.
Here’s how to read the numbers released Wednesday.
The dot plot, decoded
When the central bank releases its Summary of Economic Projections each quarter, Fed watchers focus obsessively on one part in particular: the so-called dot plot.
The dot plot shows the Fed’s 19 policymakers’ estimates for interest rates at the end of 2022, along with the next several years and over the longer run. The forecasts are represented by dots arranged along a vertical scale.
Economists closely watch how the range of estimates is shifting, because it can give a hint at where policy is heading. Even so, they fixate most intently on the middle dot (currently the 10th). That middle, or median, official is regularly quoted as the clearest estimate of where the central bank sees policy heading.
The Fed is trying to wrestle down the fastest inflation in 40 years, and to do that, officials believe that they need to lift interest rates enough to slow spending, crimp business investment and expansion, and cool off a hot job market. The central bank has been moving rates up quickly, and as inflation has remained stubbornly rapid, expectations for future increases have also climbed.
In June, the median official expected interest rates to close out the year between 3.25% and 3.5%. That has now changed, with the median official expecting rates to climb to 4.4% by year-end and to 4.6% in 2023. After that, they expect that rates will begin to come down, so that they are 3.9% by the end of 2024 and 2.9% in 2025.
The most important trick for reading this dot plot? Pay attention to where the numbers fall in relation to the longer-run median projection. That number is sometimes called the “natural” rate, and it most recently stood at 2.5%. It represents the theoretical dividing line between easy and restrictive monetary policy.
What the Fed is saying here is that rates are going to go further into economy-restricting territory — and that they will stay there through 2025.
Unemployment projections will be key
Much of Wall Street is fixated on a critical question: Will the Fed accept a much-higher jobless rate in its bid to counter rapid inflation? Page two of the economic projections holds some preliminary answers.
The Fed has two jobs. It is supposed to achieve maximum employment and stable inflation. Unemployment has been very low, employers are hiring voraciously, and wages are shooting higher, so officials think that their full employment goal is more than satisfied. Inflation, on the other hand, is running at more than three times their official target.
Given that, the central bankers are now single-mindedly focused on bringing price gains back under control. But once the job market slows, joblessness begins to rise and wage growth moderates — a series of events officials think is necessary to getting back to slow and steady price gains — the really difficult phase of the Fed’s maneuvering will begin. Central bankers will have to decide how much joblessness they are willing to tolerate, and may have to judge how to balance two goals that are in conflict.
Fed chair Jerome Powell has already acknowledged that the adjustment process is likely to bring “pain” to businesses and households. The Fed’s updated unemployment rate projections will show how much he and his colleagues are prepared to tolerate.
The new projections reinforced that, at least to some degree. Unemployment is being seen as rising to 4.4% in both 2023 and 2024, up from 3.7% currently. That’s higher than Fed officials previously saw it climbing.
“These are the unfortunate costs of reducing inflation,” Powell said last month. “But a failure to restore price stability would mean far greater pain.”
Watch the growth outlook
The road toward higher unemployment is paved with slower growth. To force the job market to cool and inflation to moderate, Fed officials believe they have to drag economic growth below its potential level — and how much it is expected to drop can send a signal about how punishing the Fed thinks its policies will be.
Many experts think that the economy is capable of a certain level of growth in any given year, based on fundamental characteristics like the age of its population and productivity of its companies. Right now, the Fed estimates that longer-run sustainable level to be about 1.8%, after adjusting for inflation.
Last year, the economy was growing much more strongly than that — it began overheating. Now, to bring inflation down, it needs to slow below that rate for some time, the logic goes. That’s why the Fed sees growth dipping to 0.2% this year and staying at 1.2% next in its projections. We ran the economy hot, and now it thinks we need to run it cold.
Pro tip: Ignore the inflation estimates
The inflation estimates in the Fed’s projections typically do not offer a lot of insight.
That’s because the Fed’s forecasts predict how the economy will shape up if central bankers set what they consider “appropriate” monetary policy. To qualify as “appropriate,” by definition, monetary policy must push price increases back toward the Fed’s 2% annual average goal over the course of a few years. That means Fed inflation forecasts always converge back toward the central bank’s goal in economic estimates.
True to form, the new forecasts show headline inflation falling back to 2% by 2025.
If there is a glimmer of utility here, it is how long the central bank sees it taking to wrestle prices back to its target level. Fed officials think that core inflation — the figure that strips out food and fuel costs to get a sense of underlying price patterns — will remain at 2.1%in 2025.
The upshot? It will be a long road back to normal, even in an ideal world.