In his last public remarks in 2021, Federal Reserve Chair Jerome H. Powell offered a blunt message: “No one knows with any certainty where the economy will be a year or more from now.”
He was spot on.
As the months ticked by this year, Powell and his colleagues at the Fed got plenty of other details wrong. Officials repeatedly underestimated inflation’s hold on the U.S. and global economies. They fell behind on controlling consumer prices, then rushed to hike interest rates at the fastest pace in decades. And every few months, they significantly revised their expectations for where the economy was headed, downgrading their forecasts for key benchmarks like inflation, economic growth and the labor market.
This week, central bankers will convene for their final policy meeting of the year, when they’re expected to raise rates by half a percentage point, a slightly slower pace than they’ve been on since the summer. They’ll also release a fresh set of projections showing how much further rates could climb, and how long borrowing costs may stay high. The central bank’s baseline rate is expected to eclipse 5% before the Fed pauses on hikes sometime next year.
But if 2022 is any indicator, the new projections could quickly become the latest example of how policymakers continue to be confounded by the covid economy. Looking back at what Fed officials expected at this time a year ago is a good reminder of just how wild the last 12 months have been. Central bankers entered the year expecting to raise rates three times in 2022, ending at 0.9%. Instead, they are almost guaranteed to close out 2022 with seven hikes behind them and the base federal funds rate at a level between 4.25 and 4.5%, after scrambling to account for surprisingly sticky inflation, Russia’s war in Ukraine and a remarkably tight labor market.
“Within a year, they are going to have raised the federal funds rate by five percentage points,” said Claudia Sahm, founder of Sahm Consulting and a former Fed economist. “The magnitude and the speed at which the Federal Reserve has raised interest rates is unexpected. And is it very unusual for the Fed to do the unexpected, unless it has to.”
Fed officials are quick to point out how difficult forecasting has become. Rate hikes also operate with a lag, and there’s no certainty around whether the economy is barreling toward a recession or could narrowly avoid one.
In remarks at the Brookings Institution last month, Powell said “we had no experience” forecasting the supply chain constraints that helped drive inflation. Those kinds of limitations mean the Fed will have to take stock of what’s happening in the whole economy, and pinpoint the conditions needed to bring down inflation, rather than relying on models alone.
“We’ll continue to make forecasts, but we’re going to have to be humble and skeptical about forecasts, I think, for some time,” Powell said. “And that calls for a lot of risk management.”
Versions of the Fed’s projections date to 2007, and the central bank publishes new ones with alternating Fed meetings in March, September, June and December. They arrive in a dense packet of hard-to-parse data. But boiled down, they reflect the median estimates (out of 19 participants of the central bank’s Federal Open Market Committee) for where GDP, inflation, the unemployment rate and the Fed’s policy rate are headed. The projections aren’t binding, and they aren’t meant to determine what officials do in the future. But they are key to central bank messaging and communication, which are designed to minimize surprises for the financial system.
In normal times – say, absent a pandemic or a war, or both simultaneously – the estimates aren’t supposed to change much. These are not normal times.
The first projections of the year were released in March, when the Fed raised rates for the first time since the pandemic, by a quarter of a percentage point. At the time, officials thought 2022 would look like this: seven rate hikes, up from the three they had forecast just a few months before. Inflation would climb to 4.3%, using the Fed’s preferred gauge. The economy would grow at a modest 2.8%, and the unemployment rate would hold strong at 3.5%.
By June, Russia’s invasion of Ukraine had dealt a major blow to global energy markets, and inflation was still on the rise. Officials ramped up their inflation fight and indicated rates might climb to 3.4%, and inflation 5.2%. Economic growth could shrink further to 1.7%, and the unemployment rate may weaken slightly.
In September, as the bank kept hammering away at demand in the economy with higher and higher interest rates, officials signaled that they expected an even more significant slowdown, penciling in higher inflation, a higher unemployment rate and economic growth that eked out at 0.2%. They also signaled rates would cross 4% and keep climbing into next year – a seismic shift in Fed policymaking, and one that some Fed watchers would soon criticize as overkill.
“Even though they realized they were off to a slow start, and that they needed to do some catching up, you can still see that they kept underestimating just how high they were going to have to raise interest rates,” said Kaleb Nygaard, an expert on Fed history and host of the Reserve Podcast. “They did not anticipate where they were going to have to go this year.”
WHAT WILL 2023 BRING?
Fed watchers increasingly expect rates will climb past 5% next year, and that the new forecasts this week will show yet another revision. Since the last projections in September, the economic picture has been mixed: Inflation data heated up one month, then cooled the next. The labor market has slowed somewhat but is still piping hot.
Last month, Boston Fed President Susan Collins told reporters that recent data had probably “increased the top” of where rates might go, adding, “we’re not there yet.” (On Tuesday, Fed policymakers will kick off their policy meeting just as new inflation data is released by the Bureau of Labor Statistics. That report alone, though, is unlikely to change the Fed’s plans to raise rates by half a percentage point.)
Over the last year, the economy did not go the way the Fed expected. But Powell’s message from late 2021 still rang true – and could be prescient for 2023 and beyond.
“If the economy turns out to be quite different from [what the Fed expected], then so will the rate,” he said a year ago. “No one will say, ‘Oh, we can’t change our policy because we wrote something down in December.’ No one’s ever said that, or will.”
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