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U.S. Economic Resilience Forces Up The Terminal Rate – June 20, 2023

A just-published report pointed out that the Fed has now increased its projected terminal policy rate for the fourth time during the current tightening cycle. While Wednesday’s FOMC meeting left the policy rate unchanged at 5-5.25%, Fed communications are maintaining a hawkish tone, underlining that the policy move was not the end of the tightening cycle and that the FOMC will have a “live meeting” in July.

The new dot plot showed that a majority of Fed participants now expect the fed funds rate to rise by another 50 bps by the end of the year. Note that in March 2022, the median Fed participant expected that a terminal fed funds rate of 2.8% would be sufficient to put inflation on a sustained path toward 2%. By yearend, they had raised the terminal rate estimate to 5.1%. They now think that a 5.6% fed funds rate will achieve its policy goals.

These upward adjustments underscore just how severely the Fed has underestimated the resilience of the economy, and the persistence of elevated inflation, over the past two years. The latest upgrade to the Fed’s estimate of the terminal policy rate was warranted, and it directionally aligns with our view that the Fed will need to take the fed funds rate well above its current level if it wants inflation to sustainably move toward 2% in the medium term.