Removing stimulus versus becoming restrictive

Fed officials continue to signal no let-up in tightening. Yes, trade frictions are a source of downside risk, but most likely growth will remain solid, the unemployment rate will continue to fall  and inflation will pick up above 2%. In turn, the Fed needs to keep tightening just to get back to neutral. Indeed, policy will probably have to get at least slightly restrictive at some point.

For now, Fed officials say they are merely removing stimulus, with policy still accommodative. In effect, they are pulling back on the accelerator, not stepping on the brake. However, the more the unemployment rate falls below the estimated “longer-run normal” level, the greater the likelihood that the funds rate will ultimately have to rise above its “longer-run normal”—i.e., neutral—level.

Based on the median dot plot numbers from the last meeting, Fed officials expect to get the funds rate back to their 2.9% estimate for the neutral level by the end of next year, and then move it up a bit more in 2020. In contrast, markets are pricing in about a 2.6% funds rate at the end of next year, and no further tightening in 2020.

The possible need for policy to get restrictive, not just neutral, is likely to become a regular talking point for Fed officials in the months ahead.

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