The Fed Funds Rate Also Rises
The Federal Reserve’s decision to reduce its benchmark federal funds rate by a half percentage point has overshadowed the more consequential increase in the longer-term estimate of the rate.
The summary of economic projections released last week alongside the Fed’s interest rate cut showed that the median forecast for the fed funds rate over the longer-term rose to 2.9 percent. This has risen three times this year, once for each of the releases of the projections. The projection is now higher than it has been since September 2018.
What this means is that Fed officials have revised up their expectations for where monetary policy will set the overnight bank lending rate in order to achieve their two percent inflation goal. In other words, they now think it will take a higher rate to sustainably achieve two percent inflation.
This is a major change in the views of Fed officials. The rate was almost unchanged from June 2019, when it first hit 2.5 percent, through December 2023. There was one month in which it slipped down to 2.4 percent but it immediately returned to the baseline. This steadiness of the projection—which lasted 54 months—was unprecedented. Since the Fed began releasing a projection for the federal funds rate in 2012, the prior record period of an unchanged projection was seven months from September 2012 through March 2013.
What Went Down Is Now Going Up and Up
The consistency of the Fed’s increases is telling. Through most of the period from 2012 through 2019 when the Fed was reducing its estimate for the longer-run fed funds rate, the movement was full of stops and starts. But Fed officials have now been raising the median estimate at every meeting this year—giving us every reason to suspect they’ll raise it again when they next release projections in December.
To understand what this means, it is important to remember that the Fed treats the two percent inflation target as a fixed point in a turning economy. The fed funds rate and the unemployment rate get adjusted around what the Fed thinks will be required for the two percent inflation target. The median expectation for longer-run rate of unemployment has been as high as five percent and as low as four percent. It is currently at 4.2 percent.
The estimate for real growth in gross domestic product has been far less changed, mostly staying around 1.8 percent since 2016 but bumping up to 1.9 percent during the second half of the Trump administration. (That increase was likely due to the fact that the tax cuts and tariffs failed to ignite the inflation that so many predicted, confirming in the minds of officials that the U.S could grow a bit faster than they had thought.)
So what we’ve seen this year has been a steady climb in the projected fed funds rate and a smaller increase in the expected unemployment rate. Which is to say, the Fed now sees the non-inflationary interest rate and the non-inflationary unemployment rate as higher.
A Quiet Criticism of Biden-Harris Economics
That’s bad news for American consumers, and a subtle criticism of the Biden-Harris economy. It means that after four years of the Democratic administration, the Fed is now convinced that Americans will have to suffer with fewer jobs and higher interest rates just to keep inflation under control.
Why focus on the longer-run rate instead of the current rate? As we have argued before, the expectation for rates over the longer run has far more influence over investment and growth than the current rate. Businesses make decisions to finance new projects based on the expected interest rate over the life of the project rather than the rate available now. That’s especially true when current rates are above the longer-run expectation because businesses anticipate being able to refinance at the lower rate.
What this means is that even though the Fed loosened monetary policy in terms of the current fed funds rate, it tightened it in terms of the projection.