The Federal Reserve raises interest rates as expected–but the dot plot has a surprise or two

No surprise: The Federal Reserve raised its short-term benchmark Fed Funds rate by 25 basis points to a range of 1.25% to 1.50% at today’s meeting of the Open Market Committee.

No surprise: The Fed and its outgoing chair Janet Yellen didn’t say anything new. The labor market continues to strengthen and economic growth has been solid. Overall inflation and core inflation have declined this year and are running below the Fed’s target of 2%.

But there were surprises in the “dot plot” that tracks opinion among Fed officials about the future course of inflation and economic growth–and interest rates.

The dot plot, in fact, sets the Trump administration and the markets up for some very “interesting” times in 2018.

According to the dot plot, the Fed continues to project that it will raise interest rates three times in 2018.

The Fed also indicated in the dot plot that it expects real GDP growth in 2018 of 2.2 to 2.6%, up from an earlier projection of 2.0% to 2.3%.

At the same time the Fed’s dot plot indicated that the central bank believes that inflation will run at 1.7% to 1.9% in 2018. That’s a drop from the earlier projection of 1.8% to 2.0%.

Which sets up for an “interesting” 2018.”

The Fed’s projection of economic growth–a median of 2.5%, up from an earlier 2.1%–is well below the 3.0% plus that the Trump administration–and the U.S. Treasury–have projected for growth in 2018 and beyond as a result of proposed tax cuts. The upper end of the Fed’s dot plot on economic growth doesn’t exceed 2.6% in 2018, 2019, or 2020. The long-run central tendency projects out at just 1.8% to 1.9%.

It’s those projections of relatively slow growth–due in the Fed’s thinking to slow productivity growth–that lie behind the central bank’s forecasts for sub-2% inflation.

If the Fed is right about its low estimate for economic growth, then its forecast on inflation is likely to be correct. And the Fed’s belief that it should raised interest rates 3 times in 2018 is aggressive on purely fundamental grounds–if justified, in the Fed’s opinion, on the basis that the central bank needs to normalize interest rates so it has some room to maneuver in the next economic downturn.

If the Fed is right, about growth (and inflation), however, the Trump administration is wrong about the power of tax cuts to increase economic growth. And the tax cuts won’t come close to paying for themselves and will instead add “hugely” to the deficit.

If, on the other hand, the Fed is wrong about growth and the economy will accelerate as the Trump administration projects, then the Fed is wrong about inflation too and it will need to raise interest rates more aggressively than it now projects in its dot plot. That would be a big surprise to financial markets.

As I said, an “interesting’ 2018.