The Fed Launches Rate Hikes

One small step for the Fed, one giant leap for the US economy.

At long last, after seven years of near zero percent short-term interest rates, the Federal Reserve unanimously decided to raise rates by 0.25 percentage points, the first rate hike since 2006. The new range for the federal funds rate is 0.25% to 0.5%, 25 basis points above the prior range.

Meanwhile, the Fed will lift the interest it pays banks to hold reserves to 0.50% from a prior 0.25%. In addition, the Fed will offer reverse repos at 0.25% to help drain reserves from the financial system so they can keep the funds rate at or above 0.25%. Another change was lifting the discount rate to 1.00% from 0.75%.

Although some analysts and commentators are saying the overall Fed statement was “dovish” – perhaps the price Fed Chief Yellen had to pay to get a unanimous policy decision – we don’t read the Fed’s statement as dovish. On net, if anything, it was mildly hawkish.

The Fed improved its assessment of the labor market, noting “ongoing job gains,” “declining unemployment,” and wrote that underutilization of workers has “diminished appreciably.” It also noted that even after today’s rate hike “monetary policy remains accommodative” and that risks to the outlook are “balanced” versus “nearly balanced” in prior statements.

These assertions are hawkish and fully offset some dovish comments elsewhere, including a reference to an edge down in survey-based measures of inflation expectations as well as multiple references to future rate hikes being “gradual.”
Ultimately, what matters the most in today’s decision for projecting future rate hikes is the “dot plot” from the Fed and that is very close to what the Fed showed three months ago, with the median decision-maker projecting four 25 bp rate hikes next year and another four in 2017. This is completely consistent with economic projections that are very little changed from three months ago and the Fed continuing to assert that policy will be dependent on the data.

Even with today’s rate hike and a median projection of four more in 2016, the Fed says the labor market will continue to strengthen and the unemployment rate will hover for multiple years below 4.9%, which is what the Fed thinks is the long-term norm.

At present, the federal funds futures market anticipates only two rate hikes next year. We think rate hikes are much more likely to come in as the Fed now projects, with the Fed raising rates at every other meeting in 2016 (once per calendar quarter). In turn, this means interest rates across the yield curve should rise a bit faster and further than the market now expects.

One open question is when the Fed will start to renormalize the size of its balance sheet, by not fully rolling over principal payments into new security purchases. Today it said it won’t do that until normalization of the federal funds rate is “well under way,” which probably means not until the start of 2017.

It is long past time for the Federal Reserve to have started raising rates. The unemployment rate is already very close to the Fed’s long-term projection of 4.9% and nominal GDP growth – real GDP growth plus inflation – is up at a 3.9% annual rate in the past two years.

Today’s rate hike isn’t going to hurt the economy; it will help the economy by signaling the eventual end to a policy that has distorted economic decisions for the past several years.

This information contains forward-looking statements about various economic trends and strategies. You are cautioned that such forward-looking statements are subject to significant business, economic and competitive uncertainties and actual results could be materially different. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time and are the opinion of the individual strategist. Data comes from the following sources: Census Bureau, Bureau of Labor Statistics, Bureau of Economic Analysis, the Federal Reserve Board, and Haver Analytics. Data is taken from sources generally believed to be reliable but no guarantee is given to its accuracy.

© First Trust Advisors

© First Trust Advisors

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