Posted on December 14, 2016

Fed Hikes Rates For First Time This Year

Rarely has there been a more widely expected result as today’s 0.25 percent rate hike by the Fed. This is the second interest rate increase since the Fed started the current process of interest rate re-normalization one year ago. Although, many had called for additional hikes earlier this year, the policy makers held the overnight rate steady until now.In today’s press release, the Federal Open Market Committee (FOMC) said it currently sees the US economy strengthening and the labour market tightening. The unemployment rate has fallen more than earlier forecasted and household spending has been rising moderately. Inflation has increased since earlier this year, but remains below the Committee’s 2 percent longer-run target, partly reflecting earlier declines in energy prices and in the prices of non-energy imports as the US dollar has strengthened. Inflation in wages, salaries and benefits have risen considerably, but still remains low. Inflation expectations remain well anchored at low levels.

One area of economic weakness highlighted by the Fed is business fixed investment. The same disappointing behaviour is evident in Canada as well as businesses have refrained from adding meaningfully to plant, machinery, equipment or software. This troubling weakness has weighed heavily on productivity.

The FOMC intends to increase the target overnight federal funds rate only gradually, which it now considers to be consistent with GDP growth of 2.1 percent next year, up from the earlier median forecast of 2.0 percent. The median forecast for 2018 remains at 2.0 percent and is up slightly to 1.9 percent in 2019. The Fed’s median estimate of longer-term potential growth remains steady at 1.8 percent, roughly in line with the Bank of Canada’s forecast for Canadian potential growth. The range of Committee forecasts is 1.6 to 2.2 percent in the US.

The Fed sees the near-term risks to the forecast as balanced. The target range for the federal funds rate is now 1/2 to 3/4 percent, which is deemed to remain accommodative, thereby supporting some further strengthening in labour market conditions and a return to 2 percent inflation.

Committee members believe that only a gradual rise in interest rates is warranted given the low level of inflation. Moreover, they expect the federal funds rate will remain below the longer-run expected rate for some time. According to the newly released forecasts of individual members, most expect to the Fed to hike rates three times next year, although the range of estimates is relatively wide. Actual rate hikes, as always, will be dependent on economic data, market movements and global developments. Most members estimate that the longer-term federal funds rate is likely to be 2-3/4 to 3.0 percent.

The markets are watching for the reaction of the President-elect to today’s Fed release. President-elect Trump accused the Fed during the election campaign of being politically motivated in keeping rates steady this year. There is some concern that the Trump administration might threaten the independence of the Fed, in direct contrast to recent presidential policy. Many are expecting PEOTUS to tweet his opinion of today’s move.

The Bank of Canada will not follow the Fed’s move. Canada’s economy is weaker than that of the US and inflation remains low. Although oil prices have increased recently owing to OPEC and non-OPEC announcements of production cuts, the future path of oil prices remains uncertain.

Longer-term interest rates around the world have spiked since the Trump election as stock markets have rallied. This has driven up mortgage rates in Canada. It is widely expected that the Trump administration will cut tax rates and increased government spending, thereby conducting a very stimulative fiscal policy. This is the reason for the rise in longer-term interest rates. The validity of this view remains to be seen, but such action would likely have most of its impact on growth in 2018 and beyond.