Rates Hikes on the Way

Mark your calendars for a rate hike on June 15. Although the Federal Reserve cut its estimate of the most likely path for interest rates this year, it still projected two rate hikes for later this year, which suggests one hike in June and then one at the end of the year after the election.

Today’s statement was more hawkish than the last statement in late January and the one dissent, from Kansas City Fed Bank President Esther George, was in favor of hiking rates by 25 basis points at today’s meeting.

What’s different in the statement? First, the Fed said the economy is growing at a “moderate pace,” which is better than the slowdown of late last year. Second, the Fed noted the recent pickup in inflation, which means it’s focused on “core” measures of inflation, which exclude food and energy. Third, although the Fed said global developments can pose risks, it took out the reference to “closely monitoring” those developments.

Perhaps the most important change to the statement, which was reiterated by Fed Chief Yellen in her press conference, was that the US economy is growing moderately “despite” global developments. In other words, all the fear and turmoil earlier this year overestimated the damage it would cause to the US and the Fed is unlikely to put as much weight on negative foreign developments again. In addition, Yellen went out of the way at the press conference to mention potential upside risks from abroad as well as from the recent rebound in oil prices.

So why not raise rates at the next meeting on April 27? Why wait until June? In our view, economic fundamentals warrant a rate hike as soon as possible. However, today’s Fed statement did not add any language suggesting a rate hike is imminent, like it added in October 2015 when it referred to the “next meeting” and then raised rates at the very next meeting in December 2015.

Compared to the Fed’s projections back in December, today’s outlook suggests two fewer rate hikes this year (50 basis points versus 100 bp), the same amount of rate hikes in 2017 (100 bp) and one additional rate hike in 2018 (100-125 bp versus 75-100 bp). It also looks like the Fed still expects the end of the rate hike cycle to come in early 2019, with a peak rate of 3.25% (versus a prior estimate of 3.5%).

The economy can handle higher short-term rates. The unemployment rate is already very close to the Fed’s long-term projection of 4.8% and nominal GDP growth – real GDP growth plus inflation – is up at a 3.5% annual rate in the past two years. Moreover, we are starting to see early signs of accelerating inflation. “Core” consumer prices are up 2.3% versus a year ago, the largest increase since 2008.

Slightly higher short-term interest rates are not going to derail the US expansion, but will help avoid the misallocation of capital that’s inevitable if short-term rates remain artificially low.

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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