MNI ANALYSIS: The Dovish Message Buried in Fed's Sept Dot Plot

--Longer Run Fed Funds Rate Drops to All-Time Low of 2.75% 

--Signals Downgrade of Economy's Longer Run Potential 

--Fed Could Be More Cautious on Rate Hikes

By Jean Yung

     WASHINGTON (MNI) - Markets might have missed a dovish message out of the

Federal Open Market Committee this week amid a rush to price in a December

interest rate hike. Even as officials reaffirmed their view for a full

percentage point increase in the fed funds rate by end-2018, they downgraded

their estimate of the longer run neutral interest rate, signaling that rates

might have less room to rise than previously thought. 

     A lower neutral rate also means policymakers are more likely to be stuck at

the zero lower bound and forced to deploy nontraditional tools like asset

purchases if needed. That suggests extra caution is warranted ahead of future

rate hikes, especially if inflation continues to disappoint. 

     That sentiment may have been lost as markets focused on the fact that the

FOMC's characterization of where the economy and rates are headed in the near

term came more hawkish than anticipated. 

     The FOMC's latest forecast for its benchmark interest rate over the longer

run fell a quarter point to an all-time low of 2.75%. That means effectively

there is less room for policymakers to maneuver before the fed funds rate is no

longer stimulating the economy. And if inflation remains below target, the

ceiling on the Fed is also lower. 

     Federal Reserve Chair Yellen said in her press conference Wednesday that

the downward revision reflects "in some sense, a view that going out many years,

aggregate demand globally is likely to be weakened by continuing low

productivity growth and aging populations."

     That's a theme that has dogged the Fed since the financial crisis. The

so-called neutral rate, the interest rate that neither stimulates nor curbs

economic growth, has fallen steadily since 2012, when the FOMC first began

publishing their estimates. At the time, officials put it at 4.25%, already much

lower than its level in previous decades. 

     Over the past several years, policymakers have said persistent factors are

holding down the rate but that it should eventually rise as the economy recovers

from the financial crisis. But that has yet to materialize in FOMC forecasts. 

     Markets, by contrast, have projected a shallower rate path than the FOMC.

Despite the Fed's forecast of four more hikes between now and December 2018,

futures markets Thursday are still only pricing in a little over two rate hikes

over that same time horizon, according to the CME Group. 

     "Market participants may have lower estimates or believe that a low neutral

rate may be more persistent," Yellen acknowledged in her press conference. 

     For now the Fed has moved closer to the market's view. Whereas eight FOMC

members had estimated the neutral rate at 3.0% in June, only five now hold that

view. Nine members see a lower neutral rate, including four who put it at 2.75%,

the new median. 

     "FOMC participants, in light of incoming data, are adjusting their views,"

Yellen said, adding "I would say they still believe that in real terms, that

neutral rate will be rising somewhat over the next few years." 

     The FOMC said Wednesday they expect to raise the current target range for

the fed funds rate from 1.00% to 1.25% a full percentage point by the end of

2018 as the economy expands at a rate faster than its potential.  

     But faced with a shortfall in inflation, policymakers might be wondering if

the economy will need higher rates to contain those pressures. 

     Yellen hinted Wednesday that the FOMC will be looking very carefully at

each interest rate move as long as inflation data continues to disappoint.  

     "We have to balance various risks," she said. "One risk is that if we

tighten policy too quickly, we may find out that -- although we don't think this

now -- that the inflation shortfall is something that's going to be persistent."

     "If we tighten too quickly, we could undermine inflation performance, leave

it at too low levels," she continued. "Inflation expectations could fall and

that could become ingrained and that could be dangerous." 

     "So that's a reason to be cautious about raising interest rates when

inflation is as low as it is," she said. 

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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