Fed announcement: And we have liftoff...Contributors Global Markets Insights Strategy Team, Dr. David Kelly
As expected, the Federal Reserve (FED) raised short-term interest rates by 0.25% yesterday, ending seven years of a near-zero interest rate policy. This was a unanimous decision, and was based not only on the economic progress that has been made over the past few years, but also on the recognition that it takes time for changes in monetary policy to affect the underlying economy.
Since its meeting in March of this year, the Fed had indicated that it would begin to raise rates once it had seen further improvement in the labour market and it was confident that inflation would move back to its 2% target. Between February and November, the unemployment rate had fallen from 5.5% to 5.0%, and core CPI inflation had risen from 1.7% to 2.0% year on year. While many called for the Fed to raise rates in September, turbulence in global markets caused them to remain on hold. Looking at the fundamentals, however, the progress made since February more than justifies yesterday’s move.
What the Fed said and did
In addition to the increase in rates, the Fed updated its economic forecasts, reducing slightly the expected unemployment rate at the end of 2016 and 2017, but leaving estimates of economic growth and inflation largely unchanged for the next two years.
The Federal Open Market Committee (FOMC) marginally reduced the pace at which it expects to increase interest rates, now forecasting four rate hikes in 2016 and another four in 2017, compared with its previous forecast of four rate hikes in 2016 but five in 2017. The key thing to watch will be how market expectations adjust to the Fed’s new forecasts, as a Fed that hikes more quickly than the market expects could lead to upward pressure on the US dollar and a de facto tightening for the US economy.
Both in the statement and in Janet Yellen’s press conference, the Fed painted a relatively upbeat assessment of the current state of the US economy in justifying yesterday’s move. However, the Fed also stressed that further increases in short-term interest rates would be gradual and that it would continue to monitor both US economic numbers and global economic and financial conditions in deciding on future rate hikes. Importantly, Yellen emphasised in her press conference that “gradual” did not mean “mechanical”, suggesting that investors should not necessarily expect one rate hike at every second meeting, despite the overall expected trajectory of four rate hikes per year. The Fed also noted that it would seek to maintain its vast balance sheet of fixed income assets until “normalisation of the level of the federal funds rate is well underway.”
How markets reacted
Stocks rallied in reaction to the Fed’s statement, the 10-year Treasury yield remained relatively stable and futures markets continued to price in only two rate hikes in 2016 as opposed to the four that the FOMC members projected. The US dollar did not move significantly in response to the Fed’s action.
Investment Implications for 2016
The Fed will undoubtedly be pleased by the reaction to its relatively dovish language, as policymakers clearly wanted to avoid the complications that could have come from a spike in either the dollar or long-term interest rates. Nevertheless, aggregate demand in the US economy looks quite strong relative to anaemic supply, suggesting that unemployment will likely fall faster than the Fed anticipates. This, combined with some edging up in inflation pressures, could pressure the Fed to implement the four rate hikes in 2016 that it anticipates but the market doesn’t. This being the case, while the Fed’s action yesterday marks a vote of confidence in the US economy and is likely to be positive for stocks, it may entail more risks to the bond market than seem implied by initial market reactions.
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