3,2,1…Liftoff. What Does ‘Liftoff’ Really Mean in Fed Policy?

In financial markets, everyone is talking about when the Federal Reserve will “lift off.” But what does “liftoff” mean when it comes to Fed policy? Liftoff is when the Federal Open Market Committee, or FOMC, raises the target range for the federal funds rate above its near zero level.

The target range for the federal funds rate, the interest rate banks charge each other for overnight loans, is currently at such a near-zero level. It’s at that range because at the onset of the COVID-19 pandemic, the FOMC recognized that the effects of the coronavirus would weigh heavily on near-term economic activity and posed risks to the economy further out.

In March 2020, the FOMC quickly reduced its target range for the federal funds rate from what was 1.5% to 1.75% down to a 0% to 0.25% range.The FOMC put in place several monetary policy actions to help offset the severe shock of the COVID-19 pandemic. For a summary, see “COVID-19’s Effects on the Economy and the Fed’s Response,” by Jane Ihrig, Gretchen Weinbach and Scott Wolla, in the September 2020 issue of Page One Economics. Also see “Here’s What the Fed Means by Tapering,” our Open Vault blog post published Nov. 10, 2021, to read about how the Fed has been winding down the asset purchases put in place during the pandemic. Lowering the target range puts downward pressure on short-term interest rates, which supports economic activity by encouraging spending by consumers and firms.

The 0% to 0.25% range is termed the effective lower bound (ELB) or zero lower bound. As shown in the graph, the target range has been at the ELB since mid-March 2020.

The FOMC Gives Guidance about Liftoff

As the economy continues to recover from the impact of the pandemic, Fed watchers are predicting when liftoff will occur. Over the past year or so, the FOMC has provided guidance to the public about liftoff.

First, in its statements, the FOMC has listed criteria that must be met. The criteria are linked to the FOMC’s assessment of how the Fed’s stance of monetary policy aligns with its Congressionally assigned dual mandate of maximum employment and price stability.From September 2020 to November 2021 the criteria was “expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” Then, with inflation exceeding the FOMC’s 2% target for some time, the criteria was adjusted in December 2021 to say “expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.” In January, the FOMC noted, “With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

Second, in the FOMC’s Summary of Economic Projections, which is released four times a year, policymakers individually report the target range they anticipate will be most appropriate at the end of each calendar year. In the December 2021 projections, for example, all policymakers showed liftoff in 2022 and the median expectation was for the target range to be centered around 0.9% at the end of 2022.

What impact will raising the target range for the federal funds rate have on the economy? Raising the target range puts upward pressure on short-term interest rates, which transmits to other interest rates and broader financial conditions. Higher interest rates increase the cost of borrowing money and raise the incentive to save, which dampens consumer spending on some goods and services and slows businesses’ investment in new equipment. Thus, raising the target range for the federal funds rate from its near zero range is a small step to remove substantial financial accommodation the FOMC has in place. This action should start to temper growth over time and assist the FOMC in bringing inflation down toward the FOMC’s 2% target.

How You Can Track the Expected Liftoff and Path of the Policy Rate

How can you get a sense of when liftoff might occur and how much the FOMC may tighten policy going forward? Besides the FOMC’s communications, there are many other sources.

• Investment banks provide projections to their clients, and their representatives often share their views with the financial news media.
• The Federal Reserve Bank of New York conducts a survey of primary dealers and a survey of market participants ahead of each FOMC meeting. The surveys ask these Federal Reserve trading partners and institutional investment firms, respectively, many economic and financial questions, including what they anticipate the path of the federal funds rate target range will be.
• Financial market data can be used to infer the expected path of the federal funds rate on any given business day. The Federal Reserve Bank of Atlanta has such a tool, called a market probability tracker. As of late January, the tracker was reporting a more than 95% chance of the FOMC raising the target range by 25 basis points (a quarter of 1%) at its March meeting and expects the federal funds rate to be above 1% by year-end.

No matter the source, these are all just expectations with underlying assumptions that should be treated as best guesses. One always needs to keep in mind that the FOMC’s actions are data dependent. This means that the FOMC will not lock in a specific future date for liftoff or additional rate hikes but instead will respond to the data and its implications for the outlook for the economy.

Notes

1. The FOMC put in place several monetary policy actions to help offset the severe shock of the COVID-19 pandemic. For a summary, see “COVID-19’s Effects on the Economy and the Fed’s Response,” by Jane Ihrig, Gretchen Weinbach and Scott Wolla, in the September 2020 issue of Page One Economics. Also see “Here’s What the Fed Means by Tapering,” our Open Vault blog post published Nov. 10, 2021, to read about how the Fed has been winding down the asset purchases put in place during the pandemic.
2. From September 2020 to November 2021 the criteria was “expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.” Then, with inflation exceeding the FOMC’s 2% target for some time, the criteria was adjusted in December 2021 to say “expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”