Liftoff! Fed fulfills market expectations with rate hike

Markets see the economy through rose-colored glasses. So far, the Fed does not.

As was widely expected by markets and Fed watchers alike, the Federal Reserve raised the target range for the federal funds rate by 1/4 percent to 1/2-3/4 percent at its December meeting. This action represented only the second rate increase this cycle and only the second rate increase in the past 10 years.

The action is important for a variety of reasons, including the fact that higher interest rates tend to slow economic activity by raising the cost of borrowing for households and business. By raising overnight interest rates, the Federal Reserve can influence long-term interest rates and make auto loans, mortgages, and corporate loans more expensive.

That said, despite this policy action, the current level of interest rates remains low and, in Federal Reserve parlance, monetary policy remains accommodative.

It is fair to say that the current level of interest rates is supportive of economic activity, but not restrictive, and reflects the Federal Reserve’s view that less monetary policy support is needed when the unemployment rate is 4.6 percent and the Fed’s preferred measure of inflation is 1.5 percent, only modestly below its 2.0 percent objective.

The punch bowl remains on the table, but there is a little less punch left.

In justifying the decision, Chair Yellen said that considerable progress had been made toward the Fed’s objectives of maximum employment and price stability. She cited over two million jobs created in the past year and a firmer outlook for inflation.

Inflation, which has remained stubbornly below the Fed’s goals for several years now, has firmed in recent months as the pass-through from prior dollar appreciation has faded and oil prices have rebounded. The strong appreciation of the U.S. dollar against its trading partner currencies makes imports less expensive for households and business.

{mosads}Falling import prices, together with the substantial drop in energy prices in recent years, have put downward pressure on inflation for almost two years. These pressures, however, have now subsided.

Oil prices have moved above $50/barrel and import prices, which had fallen for 27 consecutive months, have stopped declining. Further improvement in the domestic economy should continue to push inflation higher, but only gradually.

Wage growth remains modest and has plenty of room for improvement. Financial markets, which make assessments of inflation when they decide how much to pay for nominal Treasury securities and real inflation-protected securities, have considerably marked up their expectations for inflation in the coming years relative to just a few months ago.

Both actual and expected inflation have given the Federal Reserve more confidence that it will achieve its inflation goal by 2018, hence, less extraordinary monetary support is warranted.

While the rate hike itself was not a surprise to anyone who watches the Federal Reserve closely, markets were paying close attention to whether the Federal Reserve would adjust its forecasts for economic growth, unemployment, and inflation to take into account the likelihood of highly expansionary fiscal policy from a Trump administration.

We felt that most members of the Fed’s policymaking committee, the Federal Open Market Committee (FOMC), would be reluctant to adjust their forecasts substantially this far in advance, given the uncertainty about the composition of any tax and spending package, as well as the timing of its passage.

Historically, substantial changes in fiscal policy do not take place immediately. For example, the tax cuts of the Bush administration were passed in July. If this pattern is repeated, fiscal stimulus would be unlikely to alter economic outcomes until later this year, with the primary effect coming in 2018.

Hence, there is little incentive for the Fed to make guesses about fiscal policy at this stage and communicate to markets that it has substantially altered its outlook while details remain scarce.

Chair Yellen, in her press conference that followed the Fed’s policymaking meeting, agreed when she said it is “far too early” to judge the effects of fiscal policy and that fiscal policy was only one of several factors that influence the Fed’s policy stance. Prudence now seems the better part of valor. We expect more substantive changes in the Fed’s outlook around mid-year when details of any fiscal package are likely to be more concrete.

That said, FOMC members are required to submit a projection of the appropriate path of policy, or the federal funds rate of interest that each individual member feels would be most likely to help achieve the Fed’s inflation and employment goals. The median projection now anticipates three rate hikes in 2017 versus two when FOMC members submitted forecasts last in September.

Eleven FOMC participants believe three rate increases or more next year is appropriate, while six believe only one to two is appropriate. Chair Yellen was clear in stating that the increase in the number of rate hikes in 2017 was modest and only represented a small shift in the thinking of several committee members.

As opposed to saying the adjustments to the appropriate policy path in 2017 reflected the election and policies of President-elect Trump, Chair Yellen said the greater number of hikes expected in 2017 could be easily explained by a variety of factors, including the recent drop in the unemployment rate.

Chair Yellen, a long proponent of keeping interest rates low to support further recovery in labor markets, is likely one of the six members thinking two or fewer hikes next year remains appropriate. The Fed is not a democracy and the chair’s view carries a lot of weight. 

Altogether, the Fed pulled off its second rate hike of the past two years without significant market disruption. Financial markets so far have taken a very positive view on the President-elect’s policies and what they mean for the economy.

Equity prices have risen sharply, long-term bond yields have backed up, and the dollar has appreciated. Markets also see fiscal stimulus as inflationary when the economy is already operating at full employment.

This response and the degree of the movements to date seem reasonable to us, given what we know and could, over time, mean that the Federal Reserve could raise rates and normalize its policy stance faster than previously anticipated. That said, we do not know much at this stage and our concern is that markets are looking at the near-term outlook with rose-colored glasses, seeing only the good parts and not the potential pitfalls.

If the policies of the new administration are heavy on personal and corporate tax cuts and infrastructure spending while restrictive trade policies are pushed to the back burner, then the early market euphoria will likely be confirmed. However, a main theme of the President-elect during his campaign was a reorientation of activity away from the tradable sector to the domestic economy.

He has advocated tariffs and other restrictive trade policies as a means to this end. A heavy emphasis on reorienting trade that outweighs or offsets much of the fiscal stimulus package could mean that the market euphoria of recent weeks will be unlikely to be sustained. 

Michael Gapen is the Managing Director and Chief U.S. Economist for Barclays.

The views expressed by contributors are their own and not the views of The Hill.