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Fed Raises Rates, Sticks With Plans for One More Hike This Year

April 16, 2019

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2 years 3 months
Submitted by satya.billa on April 16, 2019

As expected, the Federal Reserve raised the target range for the federal funds rate by quarter of a percentage point at its June meeting, bringing the benchmark rate to a 1.0% to 1.25% range. The Fed also stuck to its projection of another rate hike later this year, followed by three more quarter-point increases in 2018, despite the recent drop in inflation.

However, the Fed statement also indicated that it is “monitoring inflation closely” and it slightly lowered its inflation estimate for this year. Minneapolis Federal Reserve President Neel Kashkari was the only member of the Fed’s rate-setting committee to vote against the hike.

Fed interest rate estimates mostly unchanged

Note: The “forward curve” represents future interest rates implied by the market for interest rate swaps.

Source: Federal Reserve Board, 3/15/17, 6/14/17, and Bloomberg Euro Dollar Synthetic Rate Forecast Analysis (Market Estimate) as of 6/14/17.

The biggest surprise was that the Fed also presented its plan to shrink its balance sheet. The market wasn’t expecting the Fed to reveal the plan until later this year. By announcing the plan in June, the implication is that the process could start as early as this fall.

The plan is to taper reinvestments of principal and interest gradually, and then let bonds mature off the balance sheet over the next few years. The Fed will limit the initial amount of bonds that roll off the balance sheet to $10 billion per month—$6 billion in Treasuries and $4 billion in mortgage-backed securities—for the first three months and then increase those caps over time. However, the total amount of maturing bonds will be limited to $50 billion per month. Gradually reducing the Fed’s balance sheet shouldn’t have a big impact on the market.

In her press conference after the announcement, Fed Chair Janet Yellen indicated that the Fed doesn’t plan to use the balance sheet as an active tool of monetary policy any longer.

Longer-term bond yields rose slightly after the announcement, but remain near lows for the year, which may seem counterintuitive. From a broader perspective, long-term rates have fallen relative to short-term ones, leading to a flatter yield curve. That suggests the market isn’t as sanguine about growth and inflation going forward as the Fed is.

If the Fed follows through on its plan to tighten monetary policy at a time when inflation is still below its 2% target level, the economy could slow and inflation could cool off at very low levels.

Inflation is running below the Fed’s 2% target rate

Source: Bloomberg. Consumer Price Index for All Urban Consumers: All Items (CPI) and Consumer Price Index for All Urban Consumers: Less Food & Energy (Core CPI), U.S. Personal Consumption Expenditure Deflator (PCE) and U.S. Personal Consumption Expenditure Price Index (Core PCE), percent change, year over year. Monthly data as of 6/14/17.

So why does the Fed expect higher inflation? Mainly, the low unemployment rate. Historically, when the unemployment rate has fallen below 4.5%, wages have risen, fueling stronger consumer spending and higher inflation. However, there isn’t a lot of evidence that has happened yet in this cycle. Nonetheless, the Fed appears to believe wage increases will pick up and pull general inflation higher in the months ahead. Of course, as always, the Fed’s policy is “data dependent,” which means it can change as the economic data change.

The bottom line is that the Fed’s rate hike was not a surprise and its ongoing plans to tighten monetary policy in anticipation of higher inflation were met with some skepticism by the market. The rally in the bond market and a flattening of the yield curve suggest investors don’t agree with the Fed.

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