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June 20, 2019, 1:43 p.m. EDT

Fed’s errant estimates of inflation, interest rates show folly of long-term forecasts

FOMC once saw fed funds topping out at 4.25%. And now? 2.5%

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By Jeffry Bartash, MarketWatch


Everett Collection
The Federal Reserve is finding it difficult if not impossible to predict the future path of a key U.S. interest rate that determines the cost of borrowing for businesses and consumers.

Predicting the future is a tough business. Just look at the Federal Reserve’s repeated errors in estimating inflation or the level of a key interest rate that influences U.S. borrowing costs.

Just seven months ago, central bank honchos were penciling in two increases in the Fed’s benchmark interest rate in 2019 and another one in 2020. The so-called fed funds rate was supposed to top out at around 3.1%.

By March, the Fed had ruled out any rate increases in 2019, leaving fed funds around 2.4%. And now the bank is predicting a rate cut by next year, and perhaps a lot earlier if Wall Street’s reaction is any indication.

Read: Fed has no plans to cut interest rates — but it leaves itself plenty of wiggle room

The Fed’s about-face reflects the reality of a more slowly growing economy — and another shortfall in inflation.

The central bank was convinced inflation would stick close to its 2% target this year, using its preferred PCE price gauge. Instead, inflation has tapered off so much the Fed chopped its forecast for 2019 to 1.5% from 1.8%.

The Fed has been frequently wrong about the path of the economy and the rate of inflation since the end of 2007-’09 Great Recession (and even before that).

Consider the bank’s estimate of where its fed funds rate would eventually end up. Many consumer and business loans, including mortgages, take their cues from changes in the fed funds rate.

The Fed in 2012 began offering a “longer run” forecast that started out at 4.25%. The forecast has gradually been whittled down, and on Wednesday, the Fed cut its target to a new low of 2.5% from 2.8%.

In the short run, the change doesn’t mean much. But if the Fed is right, one of its main tools to control the economy is unlikely to rise much above 2.5% in the foreseeable future.

Ten years ago, no one on Wall Street would have believed the ceiling for fed funds was less than 3%. Since the early 1980s the rate has usually been higher — much higher.

What does it mean? The Fed’s slimmed-down forecasts tell us that the era of low inflation is not about to end anytime soon. And more worrisome, that average U.S. economic growth is unlikely to return to historic norms of 3% a year.

Here’s another thing: The Fed won’t have much ammo to combat the next recession with interest rates so low — unless it resorts to extraordinary and controversial measures such as the quantitative easing used the last time around.

Jeffry Bartash is a reporter for MarketWatch in Washington.

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