The interest rate outlook has swung sharply since November 2018, with mainstream expectations now a full percentage point lower than they had been. For short-term interest rates (Federal Funds), the Wall Street Journal’s latest survey of economists shows average expectations of just two percent throughout 2020 and 2021, down from the recent 2.41%. The 10-year Treasury bond is expected to rise just 0.4% over the next two years from the current 2.14%.
Interest rate forecasts from Wall Street Journal survey of economists
The reasons for the change in outlook—the economic growth risks and lack of confidence in inflation forecasts—are also the key issues going forward. I’m skeptical about today’s standard narrative, but also too humble to be sure that it’s wrong.
Jerome Powell’s testimony to Congress was pretty moderate in his first forecast statement: “Our baseline outlook is for economic growth to remain solid, labor markets to stay strong, and inflation to move back up over time to the Committee's 2 percent objective.” This is a mainstream view, which I share.
Then the Fed chair talked risk: “However, uncertainties about the outlook have increased in recent months. In particular, economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the U.S. economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling, and Brexit.”
The second statement could be interpreted in two ways. One is that the baseline forecast is unchanged, but we acknowledge possible error on the downside. The other possible interpretation, which I think many analysts are assuming, is that the uncertainty is likely to depress economic growth. The first approach makes sense to me. The second approach is possible, but less likely. I have erred twice in recent years by connecting policy uncertainty to weak economic growth, first with respect to Brexit, and then with respect to implementation of President Trump’s policies immediately after his election. (And my doctoral dissertation was about the effect of uncertainty on business investment, so I should get this right!)
The Fed seems willing to cut interest rates just to soften the downside risk, not because projected growth is too strong. That is quite unusual for monetary policy, though not entirely silly.
The poor performance of inflation models supports this preventive approach to monetary policy. In recent years the models have over-predicted inflation. If the models are not working well, then it seems less dangerous to cut interest rates.
Economists’ basic model of inflation is that when low interest rates push spending growth faster than production can grow, inflation accelerates. It’s like the Phillips Curve (which correlates low unemployment with inflation), but clarifies that economic growth itself does not cause inflation. The challenge is that growth of production potential in the economy is unknown. We try to estimate it, but we cannot know in real time if productivity (output per hour worked) is expanding fast enough to justify more stimulus. Current economic models put substantial momentum into the inflation process, so inflation is quite sluggish. That means we can over-stimulate the economy for a little while without getting much inflation. However, momentum also means that if inflation gets too high, it will take a good bit of economic slowdown to pull inflation back down to its target.
With the standard inflation model working poorly, cutting interest rates seems not so risky. Even if the baseline economic forecast is not weak, that chance of international trade declining makes an interest rate cut more reasonable.
Although international concerns warrant worry, the most likely case is more sanguine. FocusEconomics compiles forecasts from economists around the world and compiles them into country, region and global totals. Their numbers show pretty stable economic growth is likely, just under three percent (world GDP inflation-adjusted) this year through 2021.
Inflation is likely to edge up, as it did in the June CPI report. Because of the momentum in inflation, the Fed will not want to get left behind, so will change their stance in the coming months. I expect a drop in interest rates at their July 30-31 meeting, followed by an increase late this year, with two or three further rate increases in 2020. Probably. The interest rate and inflation outlook is much less clear than it had been in the past, and every smart forecaster is humble these days.
