Policy

Monetary Policy
Fed passes in March but signals readiness to raise rates later this year.
The Federal Open Market Committee, the U.S. central bank’s policy-making arm, in March kept the 0.25 to 0.50 percent target range for the federal funds rate that it set in December 2015, which marked the first increase since June 2006.

While the decision to stand pat in March was not a surprise, the committee’s accompanying statement and its projections underscore the likely path of Fed policy this year.

First, among 17 FOMC participants, seven indicated that more than three rate increases (of a quarter percentage-point each) in 2016 would be appropriate, but nine preferred only two. Either way, given that there are only three major committee meetings scheduled for the rest of the year (in June, September, and December), if a hike does not come in June, then September would be the most likely time for another rate increase.

Second, even though the Fed lowered its projections of real GDP growth for 2016 and 2017, it still had a positive outlook for this year. The new forecast calls for 2.2 percent growth in 2016, higher than the estimated growth for 2017, 2018, and over the longer run. It appears that the Fed incorporated the recent volatility in financial markets and a global economic slowdown into its projections, but it still has confidence in a modestly growing economy in the U.S. this year.

Third, Fed officials expect labor market improvements to continue. The unemployment rate is projected to average 4.7 percent this year, falling to 4.6 percent in 2017 and 4.5 percent in 2018. The outlook for continuous improvement bolsters the Fed’s optimism about growth and should lead to higher inflation in the future, which would support a tightening monetary policy.

Last but not least, inflation remains crucial to the Fed’s policy making. In its March projections the Fed showed it has confidence in inflation moving toward its 2 percent target over the medium term. As we point out in our CPI analysis, consumer prices have remained stable in recent months, but that could soon change. As the transitory effect of declining oil prices fade, the Fed’s outlook for inflation will likely remain positive.

Based on the policy making committee’s March meeting and absent significant surprises, an interest rate increase in June or September is likely. As always, current assessments are subject to change as more data become available. While Fed Chair Janet Yellen restated in her March 29 speech at the Economic Club of New York that global risks to the U.S. economy would most likely be limited, she warned that this assessment is subject to considerable uncertainty.

Fiscal Policy
Federal budget deficit reductions may now reverse.
Ever since the recession ended in June 2009, the federal budget deficit has shrunk relative to gross domestic product, or GDP, the main measure of economic activity. In federal fiscal year 2015, which ended Sept. 30, 2015, the deficit fell to 2.5 percent of GDP, below the 2.8 percent long-term average (Chart 4).

However, now the gap between revenue and spending is expected to widen. In President Barack Obama’s 2017 budget proposal, released in February, the White House projected a rise in the deficit to 3.3 percent of GDP in federal fiscal year 2016. This increase from what the White House projected a year ago (Chart 4) suggests that outcomes were worse than expected in the past few months.

For several years after 2016, a deficit of between 2.3 and 2.6 percent of GDP is projected. This does not take into account the possibility of a significant deterioration in economic conditions, however. Because recessions are notoriously difficult to forecast, multi-year projections typically focus on the trend and ignore the fluctuations around it. But changes are inevitable and eventually will lead to deviations between the projections and reality.

If a recession does begin in the next several years, the budget deficit will be much larger than the current projections suggest. At the depth of the recent recession in 2009, the federal budget deficit reached 9.8 percent of GDP. But in early 2008, the budget projections called for a 2009 deficit of 2.7 percent of GDP. And it took five years after 2009 for the deficit to return to its long-term average value.

Beyond the possibility of a recession, there are longer-term forces that will drive budget deficits higher, both in dollar terms and as a percentage of GDP. Barring changes to the current structure, federal benefit programs such as Social Security, Medicare, and other health-care programs will add to deficits in coming decades. The Congressional Budget Office estimates that by 2026, the budget deficit will reach 4.9 percent of GDP, pushing federal debt to heights not seen since the end of World War II.

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1.Overview
2. Economy
3. Inflation
4. Policy
5. Investing
6. Pulling It All Together/Appendix