Why the Fed is ready to bring the ‘accommodative’ era to an end

Washington — With the Federal Reserve widely expected to raise interest rates on Wednesday, financial markets are focused on whether signs of an acceleration in US economic growth will prompt the central bank to ramp up the pace of monetary policy tightening.

This week’s two-day policy meeting could mark the formal end of the “accommodative” level of rates the Fed has used to support the American economy since the onset of the 2007-09 recession.

The Fed’s current policy statement has included that description of loose policy as a staple element in recent years, although officials recently have described it as out of date and likely to be removed, either this week or in the near future.

The probability the Fed will raise its benchmark overnight lending rate by a quarter of a percentage point on Wednesday, in what would be its third hike in 2018, is nearly 95%, based on an analysis of fed fund futures contracts by CME Group.

The larger question is whether the Fed reshapes its monetary policy outlook for the next few years to factor in stronger GDP growth or whether concerns about a possible global trade war or economic slowdown cause it to stick close to its current view.

GDP grew at a 4.2% annualised rate in the second quarter, according to US commerce department data released in August. The economy grew at a 2.2% pace in the first quarter.

Some analysts are expecting a more aggressive tilt, whether it comes in the policy statement due to be released at 6pm GMT, the accompanying economic and interest rate projections from policymakers, or Fed chair Jerome Powell’s press conference after the conclusion of the meeting.

“Financial markets should prepare for a more hawkish tone,” Natixis economists Joseph Lavorgna and Thomas Julien wrote ahead of the meeting.

“Another quarter of 4% real GDP growth coupled with faster wage gains is likely to cause policymakers to err on the side of aggressiveness at some point.... Investors may soon have to contend with the fact that the Fed is going to press harder to dampen ebullient economic activity.”

Managing risks

In its last round of economic projections in June, the Fed forecast the economy would grow 2.8% this year, a figure several central bank officials have since publicly notched higher.

The unemployment rate, currently 3.9%, is at a level considered beyond what can be sustained without putting upward pressure on wages and inflation, and consumer confidence is strong, having hit an 18-year high in September.

In addition, equity markets have largely sloughed off the risk that the economy will be derailed by a global trade war.

Some Fed policymakers have said they feel a recent jump in US wages is just the first of more to come.

Powell, who took over as head of the Fed earlier this year, has emphasised managing risks in a way that indicates he is more on guard about a possible jump in inflation than in trying to push unemployment rates ever lower.

Investment bank Goldman Sachs predicts the Fed will raise rates four times in 2019, faster than the three hikes suggested by policymakers in their projections in June or the two to three increases foreseen by investors.

The Fed’s benchmark overnight lending rate is currently set in a target range of between 1.75% and 2.00%.

“In light of the economy’s impressive growth momentum, the upward trends in wage and price inflation, and the limited overall tightening in financial conditions achieved so far, on net we think the risks to the funds rate are tilted to the upside,” Goldman Sachs economists Jan Hatzius and others wrote in a preview of this week's Fed meeting.

Reuters