On My Mind: Restrictive? We’ll know it when we see it.

The Fed sent a strong signal that interest rates will remain higher for longer, as our Franklin Templeton Fixed Income CIO Sonal Desai has long predicted. The Fed also started to acknowledge that the natural real rate of interest is higher than it thought. She shares her latest insights on the policy outlook and the implications for investors.

The Federal Reserve (Fed) kept interest rates on hold in its September meeting, but went out of its way to signal that the neutral interest rate is likely higher than the central bank has indicated so far, and that policy will have to remain tighter for longer—as I have long maintained.

The Fed’s new “Summary of Economic Projections” unveiled important changes to the Fed’s views and forecasts compared to June. On the macroeconomic outlook, the Fed now envisions a much stronger economy this year and next, with faster growth and lower unemployment. Gross domestic product (GDP) growth has been revised upwards by over one percentage point for this year, to 2.1%, and by almost half a percentage point for 2024, to 1.5%. The Fed now sees unemployment at just 3.8% by the end of this year, and only 4.1% in 2024 and 2025 – this compares to an already quite low path of 4.1%, 4.5% and 4.5% in the previous projections. The inflation path, however, has been left virtually unchanged, with core personal consumption expenditures (PCE) a tad lower this year at 3.7% (from 3.9%), unchanged at 2.5% for next year and close to target by 2025.1

Some analysts have been quick to criticize these forecast changes as inconsistent wishful thinking—projecting a stronger economy and labor market while maintaining the same disinflation path is overly optimistic, they argue.

I think the revised macro outlook makes sense once you put it together with the new monetary policy forecasts and signals.

I have been arguing for some time that the natural real rate of interest (the one that would be consistent with target inflation and full employment) is higher than that implied by the 2.5% long-term nominal rate in the Fed’s forecast. A higher natural rate would be consistent with the stronger growth we’ve been observing, and now acknowledged in the new Fed forecast. Indeed, Fed Chairman Jerome Powell conceded that the reason why the US economy remains so strong might well be that the natural rate is higher—in other words, that current monetary policy is not actually that restrictive. (I would add that extremely loose and loosening fiscal policy also contributes, as I argue below.)