For the third time this year, the Federal Open Market Committee (FOMC) raised its federal funds target rate range to 1-1/4 to 1-1/2 percent. It also reaffirmed the schedule of its previously announced balance sheet normalization.

The statement acknowledged the improvement in the labor market over the last few months. Participants also boosted their forecasts for real GDP to 2.5% in both 2017 and 2018 (from 2.4% and 2.1%). The labor market outlook has also improved in the eyes of most members, but according to the Survey of Economic Projections, Core PCE inflation is still expected to remain below the 2% target until 2019.

The median expectation for the policy rate is 2.1% in 2018 (unchanged), 2.7% in 2019 (unchanged), 3.1% in 2020 (up from 2.9%), and 2.8% in the longer run (unchanged).

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Key Implications

There was a lot to digest in this statement. The upgrade to GDP and unemployment paints a macroeconomic landscape that is erasing economic slack at a healthy clip. Our internal estimates of output and employment gaps show the American economy is operating at full capacity and will likely slip into excess demand territory over the next year. Empirical analysis would tell you that this is the time when inflation should start to pick up.

Yes, yes, we know that economists have been calling for inflation to return to 2% for a long time now. In spite of diminishing unemployment and well-anchored inflation expectations, actual inflation has continued to disappoint. This has not gone unnoticed by FOMC members. As noted in recent FOMC minutes, several FOMC participants fall into the “I’ll believe it when I see it” camp when it comes to inflation. This includes the two dissenting voices at this meeting – Charles Evans and Neel Kashkari.

Over the coming months, it will be important to watch the communication of incoming Fed Chair Powell for where he falls on the inflation debate and whether he is more inclined to wait for actual inflation to emerge or whether he will maintain faith in forward-looking economic models that tell him higher inflation is just around the corner.

Even as rate hikes remain gradual, the impact of this hike and likely two more in 2018 means that the Fed will be raising rates at a faster pace than its central bank peers. Interest rate differentials favor U.S. dollar assets, which provides support for the greenback.

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