The SEP Strikes Back
The Fed voted to hold the federal funds rate at 5.25% last week, but its Summary of Economic Projections (SEP), for which there's no vote, raised borrowing costs and upped the odds of a recession.
“Don’t underestimate the Force.” ~ Darth Vader
Forward guidance is the Force of monetary policy, and the Summary of Economic Projections (SEP) is one of its primary tools. Forward guidance is an approach the Fed uses to influence borrowing costs for firms and households now by signaling what it will likely do in the future.1 It was created at the end of the Great Recession when the federal funds rate was at zero, which left little scope to push down borrowing costs and boost economic activity. So, how does it work?
Financial markets are ‘forward looking’ and want market interest rates and asset prices to reflect future federal funds rates as soon as possible; as a result, forward guidance can be a powerful way for the Fed to move markets. It is also the dream tool of macroeconomic theory, which leans hard on the role of expectations in monetary policy. The Fed uses various forward guidance tools: speeches, interviews, press conferences, and forecasts.
Today’s post—with a deeper dive for paid subscribers—is on the Summary of Economic Projections. I am critical of the SEP, but I appreciate its purpose and why it deserves improvements.
Unlike changes in the federal funds rate, the Summary of Economic Projections (SEP) is a non-consensus and non-transparent tool. Each official submits their economic forecast based on their assessment of “appropriate” monetary policy. Think of it as every Fed official playing Fed Chair for the day. And one projection is the Chair’s, albeit unidentified like the rest. It is a valuable internal tool to quantify the different viewpoints of the committee, but it’s questionable how well it serves the Fed in public.
The SEP hiked.
Once again, at last week’s press conference, the Summary of Economic Projections took center stage and moved markets, even though the Fed unanimously voted, as expected, to hold the federal funds rate steady. Minus the SEP, markets would have almost certainly moved less. Instead, the SEP surprised and confused many, as witnessed by conflicting interpretations. That all-too-common occurrence is especially problematic now.
Most news coverage focuses on the median forecast across the 19 FOMC participants for the “appropriate” federal funds rate and each macroeconomic variable, like GDP or inflation.2 The so-called ‘dot’ plot with all 19 federal funds rate paths receives considerable attention in addition to the median. No one, including the FOMC, knows who’s who unless they reveal themselves. And there’s no coordination among members.
Let’s look more closely at the new SEP. The median forecast for PCE core inflation (red) and the federal funds rate (blue) are two critical pieces of information. For each variable, the first line is the new September SEP, and the second is the prior June SEP. First, the good news is that the data on core PCE inflation has come in lower than the Fed expected in June, so the median projection moved down for this year. Good. We have not seen many downward revisions to inflation in the past few years.
The projections raised the path of rates. It might not look like much, but the 1/2 percentage point upward revision to the federal funds rate next year and carried into 2025 is a big deal. It pushed 10-year Treasury yields to a 16-year high, and the stock market dropped. Some of these reactions unwound, but it’s a lesson in how powerful the SEP is. The SEP, a non-consensus, non-transparent tool, can move borrowing costs for people taking out a mortgage, student loan, or payday loan, carrying balances on their credit cards, or needing a loan to start a new business. The SEP may please macroeconomic theorists, but it’s disruptive to everyday people and not aligned with the Fed’s commitment to be “careful” now.
Finally, some interpreted the new Summary of Economic Projections as expecting a “Goldilocks” economy with higher growth and lower unemployment. But, the extra tightening in the SEP and the reaction it caused put the soft landing at risk.
Below the fold for paid subscribers, I go deeper into the SEP, including its implications for the real federal funds rate, which peaks *next* year under the SEP forecasts, and research on how forward guidance has shortened the lags in monetary policy. Subscribe to read more.