In this episode of The REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi explain the Federal Reserve’s tools for providing “forward guidance" on the anticipated direction of the economy, interest rates and inflation, and share how to interpret the Fed’s signals regarding the year ahead.
Don’t miss a single REconomy episode, subscribe today.
“The median Fed projections imply a reduction of the base rate by an additional half percentage point this year, and 25 of those basis points were already cut in the November meeting. So, if they stick to those projections, we have another 25-basis point rate cut coming in December. But, even more importantly, the projections implied another full percentage point cut next year. In other words, the Fed expects the federal funds rate to be 3.4% at the end of 2025, which is a much faster projected trajectory for lower rates than they had projected in June for the end of 2025 at 4.1%.” – Odeta Kushi, deputy chief economist at First American
Odeta Kushi - Hello and welcome to episode 103 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American, and here with me is Mark Fleming, chief economist at First American. Hey, Mark. Today, we're diving deep into the Federal Reserve's dot plots and projections. It's kind of like looking into a magic 8-ball, only slightly more reliable.
Mark Fleming - Hey, Odeta. Your use of the word slightly concerns me a bit. After all, we are talking about the Federal Reserve and dot plots. But, what a timely topic as we wait for the next Fed meeting in December, where they'll drop their latest and last projections for the year. Let's actually take a look back at how we got here, what these projections even mean, and whether they're worth betting on at all. Spoiler alert, the Fed doesn't always get it right. Remember the hairdos of the '80s? They're big, bold. I'm just channeling hard rock '80s bands right now, but all of them stood the test of time, right? Fed projections, similar vibe.
Odeta Kushi - Wow. Getting the '80s reference in early this episode, very impressive.
Mark Fleming - You bet.
Odeta Kushi - But you're right. The Fed doesn't always get it right. So let's begin with a quick history. Back in 2007, the Fed introduced what we call the Summary of Economic Projections, or SEP, which is a publication that summarizes the projections of individual policy makers.
Mark Fleming - Well, I'm surprised. I kind of felt like this is something they've been doing for a long, long time, but they've only been doing it since the Global Financial Crisis just barely a decade ago, so not as old as my '80s reference. This is the new monetary policy tool called forward guidance.
Odeta Kushi - Right? And then we have the dot plot. Fed officials started using the dot plot in 2012 at a time when the economy was still recovering from the Great Recession. More forward guidance. It's basically a projection of where each Fed official thinks interest rates should go over the next few years. So, the dot plot shows projections from 19 Fed officials. The Fed collects economic projections from each member of the Board of Governors and each Federal Reserve Bank president four times a year. These projections are released shortly after each meeting of the FOMC in March, June, September and December.
Mark Fleming - And, of course, the idea of the dot plot is to add more transparency to what the Fed is thinking about their summary of projections, the degree of consensus, or not, among the FOMC members. It's part of that larger effort to avoid shocking the markets with surprises. But, here's the thing, if you think of the dot plot like a scene from Back to the Future - Marty, Marty, anyone? It's more than an alternate timeline, where the Fed hopes things go right, but sometimes the DeLorean doesn't exactly land where you think it will. I'm on fire today.
Odeta Kushi - We're really leaning into the '80s today and early too. Well, you know, the Fed has a really tough job. The Fed projections represent each official's guess on rates, inflation and economic growth. And, if you've seen these projections over the years, you'll know that they often miss the mark.
Mark Fleming - Yeah, I don't envy them for this responsibility of economic forecasting at all. At the end of 2021, for example, the Federal Reserve forecast that it would need to raise rates three times and that its policy target rate would end 2022 below 1%.
Odeta Kushi - Ouch. Well, instead, the Federal Reserve raised the Fed funds rate seven times in 2022, ending the year with the target at 4.25% to 4.5%. That's a little off the mark there, but we should mention that projecting the economy is really hard. Like really, really hard, and I think it's pretty great that our FOMC members change their outlook based on incoming data. That's how it should be, right? But this example is meant to illustrate that we shouldn't always put a lot of weight into these projections, but that brings up the question, why do we even look at the projections?
Mark Fleming - I'm struck by, remember the term transitory, we were talking about inflation. Well, that incoming data changed everybody's mind.
Odeta Kushi - That's right.
Mark Fleming - The dot plot and the rest of the Summary of Economic Projections, or the SEP projections, gives us a sense of the Fed's mindset, their goals, and where they think the economy is heading. And, in times of uncertainty, any guide is better than no guide at all.
Odeta Kushi - Or, as the Ghostbusters would say, who you gonna call?
Mark Fleming - Very nice reference. And, in this case, actually calling the Fed seems like a good option. It is, after all, their job to manage the economy through stable prices and full employment. So, why don't we go through the latest predictions from the September SEP, and what the Fed is trying to signal with those predictions in its forward guidance. And, perhaps more importantly, how did those predictions change compared to the previous projections from June, just three months earlier?
Odeta Kushi - Yeah, it's really the change. That often provides us with a lot of information about what the Fed's thinking. So that's a great idea. It's also very timely, given that we have another FOMC meeting with projections in December, our last one of the year. So, let's start with predictions for real GDP growth. As of the third quarter of 2024, annual real GDP growth was 2.7%. The FOMC noted in their projections that growth will slow in 2025 to 2%. That's actually unchanged from the previous projections, but it does imply a slowing in GDP growth. This isn't necessarily a recessionary prediction. It's simply saying that growth will slow.
Mark Fleming - We'll get to this a little bit later, but soft landing?
Odeta Kushi - Soft landing, question mark?
Mark Fleming - Question mark. While the GDP growth projection was unchanged, the unemployment forecast did drift a little higher. According to the projections, the unemployment rate is expected to rise to 4.4% by the end of next year, which is above their June projection of 4.2%. A 4.4% unemployment rate is higher than the rate of 4.1% today, so about three tenths higher than where we are now, but significantly lower than the pre-pandemic historical average of 5.7%. Any unemployment rate in the fours is a good unemployment rate. I think within the margin of error here, yes. And, at the November Federal Open Market Committee press conference, Chairman Powell specifically mentioned that the labor market is cooling, and they don't need it to cool significantly further in order to get inflation back to target.
Odeta Kushi - Yeah, and that's actually a very important piece of information. Recall that the Federal Reserve has a dual mandate, maximum employment and stable inflation. Inflation, and we'll get to those predictions in a minute, has made significant progress towards the Fed's 2% target. In fact, headline Personal Consumption Expenditures, which is the Fed's preferred measure of inflation, in September was 2.1%, so by that measure, we're pretty darn close to the Fed's 2% target. Yes, hence rate cuts. The Fed expects the labor market to continue to moderate, but they want to prevent that moderation from turning into a job-loss recession.
Mark Fleming - That's right, you already mentioned PCE. Inflation was at 2.1% but core PCE, which excludes food and energy prices, the so-called volatile elements, was at 2.7% in September. Now, the FOMC projections for headline PCE in 2025 was 2.1% lower than where they were predicting in June, at 2.3%.
Odeta Kushi - But we're already at 2.1%.
Mark Fleming - That's right, but their expectation for core PCE was 2.2% and we're still half a percent away from that. So, the job's still not quite done. That 2.2% September projection, let's say that a little more slowly, that 2.2% September projection is a little bit lower than the Fed was projecting in June at 2.3%. Essentially, inflation has slowed down more than they were expecting just this past summer.
Odeta Kushi - This shows that the FOMC members, on average, feel a little bit more optimistic about the pace of core inflation deceleration.
Mark Fleming - So, the dual mandate of stable prices is close to accomplished. Now, the 'piece de resistance.' The dot plot, or the Fed funds rate projections.
Odeta Kushi - Yes, so that September FOMC dot plot showed that two officials saw no more rate cuts in 2024, while seven officials saw one more quarter-point cut, and another nine officials see half a percentage point more this year. One official saw 75-basis points worth of rate cuts left this year. And, looking ahead to 2025, six officials see the Fed's benchmark falling to a target rate of 3.25% to 3.5%, 150 basis points lower than its current level.
Mark Fleming - Lots of numbers here, but the point is: that is much more aggressive than the officials were actually expecting in June. In June, four officials estimated no cuts to interest rates, and seven projected one. And eight expected two, so a faster path to the longer run rate.
Odeta Kushi - Right? And, typically, we focus on the median Fed projections here, and the median Fed projections imply a reduction of the base rate by an additional half percentage point this year, and 25 of those basis points were already cut in the November meeting. So, if they stick to those projections, we have another 25-basis point rate cut coming in December. But, even more importantly, the projections implied another full percentage point cut next year. In other words, the Fed expects the federal funds rate to be 3.4% at the end of 2025, which is a much faster projected trajectory for lower rates than they had projected in June for the end of 2025 at 4.1%.
Mark Fleming - That's right. And the other important insight from the projections is the longer-term estimate of the federal funds rate. FOMC participants have to put down a prediction for 2025 - that's hard enough - 2026, 2027 and the long run. That's like forecasting the weather six months from now. Many view that longer run projection as an estimate of the neutral rate of interest. If you need a refresher on what the neutral rate of interest is, we go in depth in the previous episode, episode 102. But, essentially, it's the short-term interest rate at which monetary policy is neither expansionary nor contractionary, not too hot, not too cold, but just right.
Odeta Kushi - Right. And, in the September projections, that neutral rate was 2.9%, which is a bit higher than the projection in June at 2.8%. Currently, the federal funds target rate is 4.5% to 4.75%, so at least according to this measure of the neutral rate, monetary policy is still restrictive.
Mark Fleming - And that's why we would expect more loosening over time. So, those are the projections in a nutshell.
Odeta Kushi - But the question is, how likely are the projections to manifest?
Mark Fleming - Yes, so will they be right? Hmm, well, we can use the financial markets' opinion to see what they think of it all. The CME Fed Watch tool tracks the probabilities of changes to the fed rate as implied by the 30-day fed funds futures price. There's a tongue twister. Fed funds futures price. It's not necessarily more accurate, but it can tell us what market expectations are for the future of monetary policy, as opposed to the Fed's expectations.
Odeta Kushi - And, as of right now, and this might change by the time that this episode publishes, because they move quite a bit. But, right now, the chances of the Fed cutting rates by at least another 125 basis points by the end of 2025 are just over 20%.
Mark Fleming - So the market says, nah, don't expect the Fed to cut as much as they are saying they will. Indeed. Now, Chairman Powell touched on this in his November press conference. He mentioned that data has been stronger than expected, that is economic data has been stronger than expected, and that downside risks have diminished. As a result, bond yields have increased. Powell mentioned that the Fed will take financial conditions into account, if they're persistent and material, but that we're not at that point yet.
Odeta Kushi - Right? And, of course, we have to make the housing connection here. There is a connection to mortgage rates. We've been asked a lot recently why mortgage rates are going up, while the fed funds rate is going down. Recall that the 30-year, fixed-rate mortgage is loosely benchmarked to the 10-year Treasury bond. The expectation of the Fed's first rate cut in September quickly put downward pressure on mortgage rates, as the market very bullishly anticipated the path of future cuts. Since then, upwardly revised data, strong employment numbers, and even the election have lowered bond market expectations for future rate cuts relative to the Fed's projections, which has pushed the 10-year Treasury yield up from its mid-September low. And, unfortunately, mortgage rates have followed suit. So, the Fed's baseline expectation, by Chairman Powell's own words, is that they'll continue to move gradually down towards neutral, that the economy will continue to grow at a healthy clip, and that the labor market will remain strong.
Mark Fleming - In other words, the Fed will lower rates and believes it will achieve the otherwise thought unachievable, also known as a, soft landing.
Odeta Kushi - We'll take it, right. And, if the Fed continues on with their rate-cutting cycle, we can expect mortgage rates to drift a little lower next year. Slightly lower rates will boost affordability, ease the rate lock-in effect for sellers, and hopefully unlock some existing-home inventory. And I think we should absolutely end on that optimistic note. Thank you all for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.
Mark Fleming - Big hair, MTV, Head Bangers Ball. Does anyone watch music on MTV anymore?
Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.