Coming into to its March meeting, there was little mystery about what the Fed would do--nothing--but a lot of interest and a wide range of opinion about how it would communicate a decision to keep rates on hold. Speculation focused on three key communications:
* The "dot plot"--that is, the Federal Open Market Committee participants' assessments of the appropriate policy rate over the coming years;
* The balance of risk assessment; and
* The Summary of Economic Projections for inflation, unemployment, and NAIRU (non-accelerating inflation rate of unemployment).
The biggest surprise on Fed day was that the median of the dots now indicates only two more rate hikes for 2016, down from the four hikes in 2016 projected at December's meeting. This had the effect of moving the Fed dot plot liftoff path for 2016 and 2017 closer to market pricing, but with the latter still well below the former. As for balance of risk, whereas in January the Fed said that it was "closely monitoring" global developments and was "assessing" their implications, in the March statement the Fed has apparently finished their assessment and now concludes that "global economic and financial developments continue to pose risks." The SEP projections now show somewhat less inflation in 2016 and slightly less inflation in 2017 than was projected in December, and the median estimate of NAIRU has shifted down by one-tenth of a percentage point to 4.8 percent. What has attracted somewhat less attention is that, notwithstanding this downward adjustment to the NAIRU, the Fed projects that its policy of increasing the Federal Funds rate towards a "new equilibrium" destination at a "gradual" pace will continue to provide accommodation sufficient to push the unemployment rate below the NAIRU later this year and keep it there through at least 2018 (Figure 1). In other words, the Fed wants to run the economy--at least a little--hot and to keep the unemployment rate "lower than the NAIRU and for longer" than is typical in Fed rate hike cycles.
Given the initial conditions that Janet Yellen inherited upon becoming Fed chair in February 2014 and the Phillips curve lens through which she and key members of the Committee interpret the labor market, setting a policy path that will allow the labor market to "run hot" is an understandable choice. As shown in Figure 2, U.S. inflation as measured by the PCE deflator has consistently remained below the Fed's 2 percent target since that target was...