Fed Seen Standing Firm on Interest Rates as Economic Outlook Brightens

The Fed, meanwhile, won’t raise rates until its goals of maximum employment and sustained 2% inflation have been reached—a scenario officials have described as a long way off.

The updated economic projections Fed officials will release Wednesday, after the conclusion of the policy meeting, should show they expect the labor market and inflation to rebound faster than they anticipated in December.

The advancing rollout of Covid-19 vaccines and Congress’s completion of a $1.9 trillion economic stimulus program have brightened the outlook. But Fed officials don’t plan to signal a change to their easy-money policies until they see those projections coming true.

“We would like to see incoming actual data that show us moving closer to our goals, both for inflation and for employment, and that’s what it will take,” Mr. Powell told the House Financial Services Committee in a hearing Feb. 24. 

When Fed officials last updated their economic and interest-rate forecasts in December, their median projection showed U.S. gross domestic product would expand 4.2% in 2021 and inflation would hit 1.8%. They saw the unemployment rate falling to 5% in the fourth quarter—below its current 6.2% rate but above the 4.1% rate where officials believe it can be sustained on average over the long run.

The outlook appears to have improved since then. Private economists surveyed by The Wall Street Journal in March projected U.S. economic output would grow nearly 6% this year, better than the 3.7% growth they forecast in December. Their projections for inflation have moved up by roughly half a percentage point since then, while their projections for the unemployment rate have moved down by roughly half a percentage point.

That shift suggests Fed officials could raise their forecasts for growth and inflation in 2021 and lower their projections for unemployment as well.

“They’re going to have to raise their outlook for growth—we know that,” said Diane Swonk, chief economist at Grant Thornton LLP. “We got a lot more stimulus.”

The officials also will be updating their projections for the path of short-term interest rates, a guide to how Fed policy might evolve in the next couple of years. The so-called dot plot, which garners a great deal of market attention, in December showed 12 of 17 Fed officials anticipated their benchmark federal-funds rate would remain pinned near zero through 2023.

Investors are now calculating the Fed might raise the rate sooner than that. Futures markets are pricing in an increase by as early as the second quarter of 2022, according to Roberto Perli, a strategist at Cornerstone Macro.

“The key question is, do any members of the committee adjust their rate expectations for 2023?” said David Wilcox, a senior fellow at the Peterson Institute for International Economics, who served as the Fed’s research director from 2011 to 2018.

Investors are betting that higher inflation will pressure the Fed to raise interest rates sooner than the policy makers expected in December. That could happen, some economists say, if businesses struggle to keep up with a surge in demand as consumers emerge from the restrictions of Covid-19 in the months ahead.

While Mr. Powell and his colleagues have welcomed the economy’s brightening prospects, they say the outlook remains clouded with uncertainties. Among them are a labor market that is 9.5 million jobs shy of pre-pandemic levels and the prospect that emerging Covid-19 variants could render vaccines less effective, prompting new restrictions on businesses and schools.

After 10 years of inflation largely running below the Fed’s 2% target, officials last year scrapped their longstanding practice of lifting interest rates to pre-empt rising prices. They now say they want to see inflation expectations rise somewhat above 2% before they will raise rates.

But no one knows exactly how high the Fed would be comfortable seeing inflation rise, or for how long. Some analysts say that uncertainty has fueled speculation that the central bank will move sooner than officials have implied. That, in turn, contributed to a big jump in market interest rates that could lessen the effectiveness of the Fed’s stimulative policies.

“When you make it this vague, you sort of undermine that hoped-for achievement” of lower unemployment, said Alan Blinder, a Princeton University economist who served on the Fed board from 1994 to 1996, of policy makers’ inflation tolerance. “Market participants start pulling forward—and you can see this—their anticipated first interest rate hike.”

Yields on 10-year Treasury notes, which affect long-term borrowing costs for businesses and households, have surged in recent weeks to the highest level since February 2020, before the pandemic hit the U.S. economy. Rates on 30-year mortgages rose above 3% this month for the first time since July.

To counter a parallel jump in yields that has taken place across the Atlantic, the European Central Bank said last week that it will step up the pace of its own bond purchases.

Mr. Powell and his colleagues haven’t expressed concern so far about the rise in long-term yields, which many economists say are consistent with an improving economy.

His communications after the meeting will likely strike a cautious tone. He doesn’t want to spook the markets and undermine the economic rebound he is trying to help engineer.

“They are very conscious that all eyes are on them,’” said Tim Duy, chief U.S. economist at SGH Macro Advisors LLC. He expects the Fed to stick to the message that it is too early to even consider a change in course. “They’re not going to want to do anything that interferes with that just yet.”

Write to Paul Kiernan at [email protected]