Confident Fed Sets Stage for December Rate Hike

In its statement, the Fed pointed to the strength of job growth and to increases in household and business spending. It noted that inflation has weakened in recent months, but predicted a rebound.

The official optimism went only so far, however. The pace of growth remains weak by historical standards, and the Fed indicated that it sees no evidence of a turn toward stronger growth.

Officials once again reduced their expectations for future rate hikes. The median prediction is now that the benchmark rate will stabilize at 2.8 percent, down from a median estimate of 3 percent in June.

Fed officials also expect both low unemployment and low inflation to persist over the next several years, a curious combination that economists are struggling to understand.

Fed officials predicted that inflation would rebound modestly next year, approaching the Fed’s target of a 2 percent annual pace. But they predicted that inflation would not rise above that 2 percent target, even though they expect unemployment to remain well below the level that would usually result in inflation.

Officials predicted unemployment will stay near 4 percent for the next three years.

The Fed must decide how soon to resume interest rate hikes. The central bank has raised its benchmark rate twice this year, in March and June, and markets were expecting at least one more increase this year. The rate now sits in a range between 1 percent and 1.25 percent, a level most Fed officials regard as providing modest encouragement for increased borrowing and risk-taking.

Some economic indicators suggest higher rates are warranted: The unemployment rate, at 4.4 percent in August, is below the level most officials regard as sustainable, which the Fed historically has treated as a signal for higher rates.

But other economic measures paint a contrasting picture of economic health. While job growth remains strong, wage growth is modest and inflation weakened in recent months.

The Fed’s preferred measure of price inflation increased by just 1.4 percent during the 12 months ending in July, the most recent available data. The Fed is likely to undershoot its target of 2 percent annual inflation for the sixth consecutive year. That has caused consternation among some economists and Fed officials, who are wary of raising rates given the Fed’s inability to so far achieve its inflation objectives.

In a speech this month, Fed Governor Lael Brainard cited a “notable disconnect between signs that the economy is in the neighborhood of full employment and a string of lower-than-projected inflation readings, especially since inflation has come in stubbornly below target for five years.”

The Fed’s next meeting is scheduled for October 31 and November 1, but the Fed is unlikely to raise rates any sooner than its final meeting of the year, in mid-December.

The Fed’s plan to shrink its $4 trillion portfolio has been well choreographed for months, with the central bank outlining in June its plans to slowly reduce its balance sheet by decreasing reinvestment of the principal payments it receives on its bond holdings. To avoid surprising markets or injecting volatility, the Fed plans to gradually reduce its holdings by $10 billion a month.

The central bank, which began its bond-buying program to drive down borrowing costs in the wake of the financial crisis, is now convinced that the economy is strong enough to operate without that level of government support

The retreat will put modest upward pressure on borrowing costs, but businesses and consumers are unlikely to see much difference in the near term. “You will see a gradual tightening of financial conditions that will come from the Fed shrinking its balance sheet,” said Lewis Alexander, chief United States economist at Nomura Securities.

Still, questions remain, both about how markets react and where the Fed will decide where to stop. Before the crisis, the Fed held less than $900 billion in assets, and most analysts expect the Fed to maintain a significantly larger balance sheet going forward — both because the financial system has grown and because the Fed has expanded its role in maintaining the system.

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