The Federal Reserve left the federal funds rate unchanged at 1.5%–1.75% yesterday, as expected. Furthermore, 13 of the 17 FOMC (Federal Open Market Committee) members expect the interest rate to remain the same in 2020. Markets reacted favorably to the Fed’s decision. The S&P 500 closed 0.3% higher, while the Dow Jones ended 0.1% higher yesterday.
Even though the Fed’s decision to hold the rate constant was widely expected, Donald Trump was pushing for lower interest rates. However, the Fed bases its interest rate decisions on three key indicators—economic growth, inflation, and the unemployment rate.
Economic growth and interest rates
Chairman Jerome Powell noted at the Fed press conference that the US economy has grown for 11 years straight. A healthy job market, rising incomes, and strong consumer confidence have resulted in strong household spending. The strength in household spending, however, contrasts with business investments and exports, which are weak. Moreover, manufacturing output has fallen over the past year. Powell noted that slower global economic growth and trade disputes have impacted the manufacturing sector and business investments.
Despite the weakness in manufacturing and investments, the overall US economy is growing at a moderate pace. The Fed expects the economy to continue growing at a moderate pace on the back of the strong household sector and monetary policy. This expectation supported the Fed’s decision to keep interest rates flat. FOMC members expect GDP growth to slow slightly over the next few years, but to stay close to 2%.
Unemployment rate near 50-year lows
The unemployment rate in the US has been near 50-year lows for more than a year now. Additionally, job growth has remained strong, and wages are rising. The country has seen broad-based employment growth. The Fed expects a strong job market, and FOMC members expect an unemployment rate below 4% for the next several years.
Why the Fed is targeting 2% inflation
The Fed is targeting an inflation rate of 2% in the long term. However, personal consumption expenditure inflation was at 1.3% in the year up until October. In comparison, core inflation was 1.6%. As core inflation excludes volatile food and energy prices, it is considered a better indicator of future inflation.
Therefore, low and stable inflation is not a bad thing in itself. However, if inflation levels are consistently lower than targeted, they pull down longer-term inflation expectations, which may push actual inflation even lower. With interest rates already at low levels, such a scenario leaves little tools available for the Fed if the economy falters. Therefore, the Fed aims to keep inflation at around 2%. FOMC members expect inflation to rise to 1.9% in 2020 and 2% in 2021.
Interest rate outlook for 2020
The Fed believes that the current monetary policy is well positioned to support continued economic growth, a strong job market, and inflation near the 2% target. The Fed intends to keep the rate unchanged if the economy remains broadly consistent with this outlook. It intends to monitor the impact of its 2019 rate cuts before making any further changes in rates. To learn more, read After Rate Cut, Powell Puts the Ball in Trump’s Court and France, Brazil, Argentina: Trump’s Latest Tariff Targets.