What to expect from the Fed in 2019

The Federal Reserve says it expects low unemployment and rising inflation will keep it on track to raise interest rates at a gradual pace over the next two years. By late 2019, the Fed says its key policy rate should be at a level that will be slightly restrictive for growth.

The Fed’s projection on rate hikes came with the release of the central bank’s semi-annual monetary report to Congress. Fed Chairman Jerome Powell is scheduled to testify on the report on July 17 and 18.

In June, the Fed raised its policy rate for a second time this year and projected two more hikes in 2018. The monetary report says the expectation is that further hikes will leave the rate slightly above its neutral level by late next year.

The Fed’s current projection for the neutral rate—the point where monetary policy is not stimulating growth or restraining it—is 2.9%. With the June rate hike, the current range for the policy rate, known as the federal funds rate, is 1.75% to 2%.

The policy report says that officials’ median outlook for the future course of interest rates would put the policy rate “somewhat above” the neutral rate by the end of 2019 and through 2020.

The report noted that the median projection for the funds rate has it rising to 2.4% by the end of this year, which would indicate two more rate hikes are upcoming in 2018, and then climbing to 3.1% by the end of 2019 and 3.4% by the end of 2020.

That forecast would mean that the Fed’s interest rates would cross a major milestone next year toward a point where Fed interest rates are no longer being kept low to boost economic growth and will instead begin to slightly restrain growth in an effort to make sure that low unemployment does not cause the economy to overheat and trigger rising inflation.

The Fed’s interest rate has not been restrictive for over a decade. In response to the 2008 financial crisis, the Fed cut its policy rate to a record low near zero in December 2008, and kept it there for seven years. It boosted rates by a modest quarter-point in both 2015 and 2016, and then raised rates by three times last year as the economic recovery finally began to gain momentum.

The monetary report noted that worries about rising trade tensions had caused a period of turbulence in financial markets earlier this year.

In his interview with the radio program “Marketplace” on Thursday, Powell said that Fed officials have been hearing a “rising level of concern” from business executives following the tough talk from the Trump administration, which has imposed penalty tariffs on a number of countries in an effort to open markets for U.S. goods. The effort has provoked retaliation, and now the world’s two biggest economies, the United States and China, are in a full-blown trade war.

But, in the interview, Powell said he was “very pleased with the results” of the Fed’s gradual pace of rate hikes.

Powell was tapped by President Donald Trump to succeed Janet Yellen in February as Fed chairman. Trump, during his campaign, was highly critical of the Federal Reserve, accusing officials of keeping rates at ultra-low levels to favour Democrats.

While Trump has not attacked the Fed since becoming president, Larry Kudlow, his chief economic adviser, said in a recent interview that he hopes the Fed would raise interest rates “very slowly,” comments that were seen as breaking more than two decades of precedent where the White House has refrained from commenting on Fed policies.

However, Powell said he was not concerned that the Trump administration might try to exert pressure to influence the Fed’s actions on interest rates.

Increased economic activity

“Economic activity increased at a solid pace over the first half of 2018, and the labor market has continued to strengthen,” the July 13 report to Congress says.

Inflation has also moved higher. In May, the Fed writes, “[…] the most recent period for which data are available, inflation measured on a 12-month basis was a little above the Federal Open Market Committee’s (FOMC) longer-run objective of 2 percent, boosted by a sizable increase in energy prices.”

Along with evidence that U.S. growth may have stepped up in Q2, the Fed says, “Gains in consumer spending slowed early in the year, but they rebounded in the spring, supported by strong job gains, recent and past increases in household wealth, favorable consumer sentiment, and higher disposable income due in part to the implementation of the Tax Cuts and Jobs Act.”

Meanwhile, housing activity has “leveled off,” the report says.

Regarding financial conditions and stability, the central banks finds domestic financial conditions for businesses and households are supportive of U.S. growth. The Fed credits factors such as strong equity prices—following 2017 increases—and steady corporate bond issuance, as well as expanding credit options for “households with strong creditworthiness,” and “generally supportive” foreign financial conditions.

Read: U.S. banks strong enough to survive a shock: Fed

Further, “The U.S. financial system remains substantially more resilient than during the decade before the financial crisis,” the report says. One reason for that is vulnerabilities tied to “leverage in the financial sector remain low, reflecting in part strong capital positions at banks, whereas some measures of hedge fund leverage have increased.”

Oil prices are also a boon. Even though they’ve climbed rapidly and could “restrain household consumption in the United States,” the central bank says, negative effects on GDP and consumers are “likely to be offset by increased production and investment” in U.S. energy.

“Consequently, higher oil prices now imply much less of a net overall drag on the economy than they did in the past,” the report notes, especially as production grows.

The report’s mentions of U.S. trade policy are mainly restricted to how trade talks are weighing on currencies, including the loonie and peso, and international equities, particularly those of emerging markets.

However, there were a couple of mentions of how, in discussing appropriate monetary policy, the Fed acknowledges that “shifts in trade policy or developments abroad could weigh on the expansion” and create downside risk.

Read the full report.

Also read:

What growing protectionism could mean for financial standards

Where oil prices are headed, and why

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