Will the Fed's Predictions for the American Economy Come True?

Samuel Rines

Economics, North America

2018 could turn out to be an interesting year for the economy.

At its final meeting of the Yellen era, the Federal Reserve raised rates. But that doesn't really matter. Everyone expected the Fed to raise interest rates, and it delivered. What made people nervous was future moves by the Fed. Specifically, how would the Fed react to tax reform? And the Fed answered by suggesting it would not attempt to counteract it.

The Fed’s willingness to avoid counteracting the potential economic tailwind from Trumponomics is an important step in understanding the dynamics of 2018. With a tax reform package, the U.S. economy could accelerate in 2018. That is quite the statement given that the U.S. economy is nearing a decade long expansion.

One of the more pressing questions heading into the Fed meeting this week was how the Fed would react to this possibility. There were two possibilities. First, the Fed could see tax reform and coming too late in the cycle, the potential for overheating the economy, and therefore hint at an accelerated path of tightening to counter it. Alternatively, it could sit back and take the inflation and growth as a welcome reprieve from the past few years.

The answer was clear: take the inflation and growth from the tax reform, interfering little. Taking this route made sense for the Fed. It was already guiding markets toward three hikes in 2018, and the market already has two priced in. Without imminent tax reform, three was likely to be overly aggressive. But with tax reform highly likely to be passed, sticking to its previous guidance was not shock to the system.

With "most" of the participants accounting for tax reform in their projections for growth and inflation, the Fed raised estimates for growth in 2018 by 0.4 percent, but the estimate for inflation remained flat. This “growth without the inflation” prediction is one of the more interesting takeaways. The Fed’s mandate revolves around full employment and a stable price level. With the unemployment rate a 4.1 percent, the critical piece of the puzzle now is inflation. Even with the tax reform kicker, the Fed does not see accelerating inflation pressures, and therefore there is no reason to accelerate interest rate hikes. It is not a difficult calculus.