Fed Shocks No One and Raises Rates

Key Points

The Fed raised the federal funds rate by 25 basis points and now expects three additional hikes in 2017.
The Fed noted the "considerable" rise in inflation expectations and combined with the higher "dots plot" in 2017, the statement was seen as more hawkish than expected.
Next year could be a year when the Fed’s expectations (dots) actually resemble reality, which was not the case in 2016.

The Federal Reserve surprised no one today and the vote was unanimous. The Federal Open Market Committee (FOMC) raised the federal funds rate by 25 basis points—to a range of 0.50-0.75%—for the first time this year; having raised rates initially a year ago at this same time. The Fed also raised the discount rate to 1.25% from 1.0% and the rate paid on required and excess reserves to 0.75% from 0.5%. Also moving up were the Fed's expectations for the trajectory of rate hikes in 2017; with three additional hikes expected in 2017, up from two last September (based on median estimates of FOMC members).

The gross domestic product (GDP) and employment data within the Summary of Economic Projections all improved slightly, while the outlook in the statement was generally an upgrade from September's. In general, the change in expectations for next year were seen as evidence of a slightly more hawkish Fed.

"Considerable" inflation pressures?

Of note in the accompanying statement was the use of the term "considerably" to describe the increase in inflation expectations; and the mention of tightening labor conditions. The Fed said monetary policy supports "some further strengthening in labor market conditions and a return to 2 percent inflation." The addition of the word "some" was seen as an indication that there will be more muted improvement in job growth next year; while "strengthening" replaced "improvement" from the Fed's September statement.

Although expectations for future rate hikes lifted, the Fed's statement did repeat verbatim the language about the pace of rate hikes: "The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data."

Dots plot thickens

Below is an updated chart of the so-called "dots plot" which shows where members of the FOMC think interest rates will (or should) be in the next few years. The solid lines represent the current projections and the dotted lines represent the prior projections as of September.

As you can see, both the Fed's expectations (blue lines) and the market's expectations (maroon lines)—the latter based on the fed funds futures market—moved higher relative to the September meeting’s trajectory. The Fed's dots are now 28 basis points, 23 basis points and 40 basis points higher than they were at the September meeting for 2017, 2018 and 2019, respectively.

Fed estimate based on median Federal Open Market Committee (FOMC) projections. Market estimate based on Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (EDSF). Source: Bloomberg, Federal Reserve.

Keep in the mind that the Fed's dots plot has never been seen as promissory, even if markets sometimes look at it that way. That said next year could be a year when the Fed's dots actually resemble reality; or possibly even a year when the Fed has to overshoot its current expectations if inflation heats up. Of note, past adjustments to the dots have been successively revised in the same direction.

Initial market impact

In the immediate aftermath of the Fed's announcement U.S. stocks sold off; with the Dow Jones Industrial Average giving back over 200 points and moving from the green to the red on the day, before rebounding toward the close of trading. The bond market also sold off, with the yield on the 10-year Treasury note moving higher (remember, bond yields and bond prices move inversely). On the upside was the U.S. dollar, up over 1% from the low of the day.

The convergence (seen in the chart above) between the Fed's expectations/dots and the market's expectations/dots ostensibly lessens the risk of surprise Fed decisions in 2017. However, given the Fed's expectation of three hikes, the March 2017 meeting is likely to be considered "on the table." Uncertainty around the timing of the next hike—as well as continued strength in the dollar—could lead to some market volatility.

Press conference highlights

Of course, the incoming Trump administration has promised a significant amount of fiscal stimulus—through both tax and regulatory policy, in addition to government spending. At the beginning of Fed chairwoman Janet Yellen's press conference today she noted that some Fed officials may have already taken account of potential fiscal stimulus when establishing their federal funds rate projections, but she suggested most had not. This is another reason why many now believe there is a risk the Fed will have to move more aggressively next year—if Trump's policies lead to a meaningful pick-up in growth.

Yellen was asked about Trump’s proposed policies. Although she mentioned her staff had been in touch with the Trump transition team, she also said, "I am not going to offer the incoming President advice about how to conduct himself on policy." It’s a (good) sign that Yellen values the Fed's independence. Yellen also fielded a question about her term and she did say she "intends to serve out my four-year term" (which ends in 2018); and that although she "could extend her time on the Fed as a board member, it’s a decision for another day."

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

(1216-S483)

Fed Shocks No One and Raises Rates

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