On June 14, the Federal Reserve raised its policy benchmark interest rate for the fourth time since the current U.S. economic expansion began in mid-2009. The federal funds target range now sits at 1.00%-1.25%, up from 0.75%-1.00%. The Fed last raised interest rates in March.
Fed Chair Yellen and other FOMC members took this action not because they believe the U.S. economy is overheating but because they are confident it no longer requires extraordinarily accommodative monetary policy. In May, the U.S. unemployment rate fell to a 16-year low of 4.3%, and inflation, while not quite at the Fed’s 2% target, appears likely to pick up with the economy growing above 2%. The FOMC continues to regard 3% as the “equilibrium” interest rate at which policy would be neither loose nor tight, but it does not anticipate reaching that level until the end of this decade.
The Fed’s updated economic forecasts were little changed. While its median forecasts for inflation in 2017 are lower today than they were in March, the central bank still believes it will hit its 2% target in both 2018 and 2019 or, as the Fed would call it, over the medium term. The so-called “dot plot” of Fed rate expectations was also little changed. The median FOMC member still believes the committee will hike once more this year and three times next year.
In her press conference following the meeting, Chair Janet Yellen provided more details on the Fed’s plan to reduce the size of its balance sheet, which grew substantially from 2009 to 2014 as the Fed was buying securities in the open market through its quantitative easing program. The plan for shrinking its assets to a more normal size calls for initially allowing up to $10 billion of maturing securities to roll off without reinvestment each month. This figure would grow to $50 billion after a year, a more substantial amount than we had expected. The lack of reaction in bond markets to the news could mean one of two things. Either the market anticipated the Fed’s announcement or it believes the final plan will be more modest in scope and size than the proposal.
Why does this rate hike matter?
According to economic textbooks, higher interest rates ought to translate into restrictive financial conditions and slower growth. But this has not happened since the Fed began raising its target rate 18 months ago. In fact, if anything, financial conditions have eased of late, and the U.S. economy has picked up some steam after a sluggish first quarter. This is probably just fine with the Fed, which is more interested in normalizing interest-rate policy than in pouring cold water on growth.
The Fed’s plan to normalize both the level of interest rates and the size of its balance sheet will be the primary market focus after today’s widely expected policy gesture. Considering the absence of any meaningful change to the path of rate hikes that the Fed first outlined in March, we will be watching closely for evidence that the cumulative rise in short-term rates over the past 18 months is having a discernable cooling effect on economic growth. So far, evidence for this has been scant.
What was the market reaction?
The initial reading of the Fed’s statement and forecasts was slightly hawkish, given expectations of a flatter dot plot or even larger downward revisions to their inflation forecasts. The level of the 10-year Treasury yield and the U.S. dollar both rebounded after moving sharply lower earlier in the session. Equities were little-changed, trading close to flat for the day. The Fed Funds futures market is pricing in only a 42% chance of another interest rate hike this year despite the Fed’s forecast showing a clear majority of the committee still expects one.
What is our outlook?
Given a dearth of broad inflationary pressures, we believe the Fed will begin to decelerate its pace of target-rate increases from here despite the tight labor market. In fact, we see considerable risk that the Fed will end up hiking more gradually than it currently intends through the end of 2018. The U.S. Treasury yield curve has flattened, with longer-term rates falling this year while short-term yields, which tend to be sensitive to Fed policy, have risen. Because a flat or inverted yield curve is often seen as a sign of economic weakness, the level of longer-term interest rates limits how high the Fed can raise shorter-term rates. If the 10-year U.S. Treasury yield fails to climb as we anticipate over the balance of this year, the Fed will have limited scope to hike.
In addition, the lack of fiscal stimulus from Washington, D.C., may preclude the need for additional monetary tightening. While Yellen has remained coy on how she would respond to increased spending or tax cuts, these measures would in all likelihood force Fed action to prevent economic overheating. With no such bills close to passage, however, the Fed does not have any stimulus to offset.
We are forecasting just one more rate hike this year, in December. We expect the Fed to initiate its balance sheet reduction plan at the September meeting. Just two Fed rate increases are likely in 2018, bringing the terminal target range to 1.75%-2.00% by the end of next year.