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The Federal Reserve's high-stakes guessing game

With evidence that the U.S. economy is rebounding from a winter slump, the Federal Reserve, led by Federal Reserve Chairwoman Janet Yellen, on Wednesday will likely signal that an interest rate increase is coming – just not quite yet.

WASHINGTON – The Federal Reserve on Wednesday will unveil the latest version of its strategy for righting the American economy. But the question is: Will anyone believe it?

The nation’s central bank repeatedly has pushed back plans to raise its benchmark interest rate, known as the federal funds rate. The rate helps determine the cost of borrowing money for everything from a new home to a new factory. When the central bank wants to stimulate the economy, it lowers the fed funds rate. When the Fed wants to rein in growth, it raises the rate.

Since 2008, the fed funds rate has been near zero, the economic equivalent of flooring the gas. Now, the Fed is preparing to lift its foot off the accelerator. Forecasts published this spring showed most top officials expected they would raise the target interest rate this year – likely twice.

In Fedspeak, the forecasts are known as the “dot plots.” In March, the median estimate for the fed funds rate at the end of the year was 0.625 percent. At the end of next year, it’s 1.875 percent, suggesting an increase about every other time officials meet in Washington to discuss policy. In the long run, officials believe the fed funds rate will settle at 3.75 percent.

But outside the Fed, expectations are that officials will prove much more reluctant to withdraw their support for the recovery. The most likely dates for the central bank’s first move are in October or December, according to prices on fed funds futures contracts. Analysis by CME Group shows the odds for those dates are slightly better than 1 in 3, the most of any meeting. The late start date implies the Fed will hike rates only once this year, not twice, as officials believed in March. And the likelihood that the central bank will have to delay until next spring almost is the same as the chance of a liftoff in September.

The Fed will release updated projections Wednesday after officials meet in Washington for their regular policy meeting. The new projections are expected to more closely mirror the market’s timeline. Yet investors still are betting there’s a 20 percent chance the fed funds rate will be at zero when the calendar flips to 2016. The International Monetary Fund, in a rare move, is urging the U.S. central bank to wait to raise the rate until next year.

“The market recognizes that the Fed has repeatedly erred on the optimistic side,” said Eric Lascelles, chief economist at RBC Global Asset Management. “Fool me 50 times but not 51 times.”

Even the government’s official budget forecasters are dubious of the Fed’s own forecast. Before data was released showing the U.S. economy shrank early this year, the Congressional Budget Office pegged the fed funds rate at 0.4 percent in December and just 1.3 percent in 2016. The median Fed forecast in 2017 is 3.125 percent. The government comes in at 2.4 percent that year, and it doesn’t catch up to the Fed’s longer-run estimate until 2019.

Fundamentally, the mismatch between the Fed and the outside world reflects different pictures of the economy. Investors and the government believe the recovery will turn out to be weaker than the Fed thinks – and for good reason. The Fed repeatedly has predicted that a robust 3 percent growth rate was just around the corner, only to watch the recovery’s momentum dissipate.

That was the case this year. Back in December, officials estimated the economy would grow between 2.6 percent and 3 percent this year. They lowered the range in March to 2.3 percent to 2.7 percent. It almost is certain they will reduce the forecast again when they meet this week. On the other hand, the Fed also has been too pessimistic about the labor market: The unemployment rate has fallen much faster than anticipated, which could push officials to raise rates more quickly.

The Fed also has cautioned against reading too much into their interest rate forecasts.

The other caveat is that the Fed does not speak with one voice: Its top ranks include a seven-member board of governors based in Washington and 12 reserve bank presidents based across the country. Only the board and four reserve bank presidents at a time actually get to vote on policy issues. Even within that group, some officials – such as the chair – are more influential than others.



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