Fed Hikes Rates, Highlights Yellen’s Strategy of Gradualism

Fed expects to hike interest rates three more times in 2017

The Federal Open Market Committee (FOMC), which met in Washington on December 13th-14th, 2016, increased its benchmark rate by a quarter percentage point to a range of 0.50% to 0.75% for the first time in 2016. The Fed’s overnight funds rate is currently at 0.41%. The Fed has also indicated that it expects to hike rates three more times in 2017, two or three in 2018, and three in 2019, as inflation expectations have increased considerably along with the strengthening of labor market conditions. New projections show that central banks are expecting three quarter-point rate increases in 2017, up from the two seen in the previous forecasts in September 2016. Fed officials had left unchanged the target range for the benchmark federal funds rate at a range of 0.25% to 0.50%, where it has been since December 2015, at all its six meetings held in 2016.

Source: FOMC, Bloomberg
Source: FOMC, Bloomberg

Federal Reserve Chairperson Janet Yellen, who testified before the Joint Economic Committee of Congress in Washington D.C. on November 17th, 2016, indicated that the Fed is inching closer to rising interest rates as the labor market continues to strengthen and inflation inches higher. Yellen hinted that a rate hike could be implemented soon if economic data continue to progress toward the committee’s objectives. In its earlier meeting on September 20th-21st, 2016, the FOMC said that although near-term risks to the economic outlook appeared roughly balanced, it would wait for further evidence of continued progress toward its objectives before rising rates.

In November 2016, US nonfarm payrolls increased by 178,000 jobs, after growing 142,000 in October 2016, according to data released by the US Department of Labor on Friday, December 02nd, 2016. The unemployment rate also fell to nine-year low to 4.6% from 4.9% in October 2016, after more people found employment. The US unemployment rate is still slightly above the Fed’s estimate for the lowest sustainable level of joblessness. However, Yellen noted that a tightening labor market was beginning to produce higher wage gains, which should eventually help boost inflation to the Fed’s goal of 2%.

Yellen’s gradualism policy pays off

At a press conference after the Fed raised its benchmark lending rates, Yellen stated that the economy is strong and will improve further, allowing the Fed to continue to raise rates in 2017. She also said that the labor market probably does not need fiscal stimulus to achieve full employment, and that monetary policy was about on target as inflation approaches the 2% goal. As the Dow Jones Industrial Average inches closer to reaching the 20,000 mark, she said rates of return in equity markets are in line with historical ranges.

The US economy has made significant progress in 2016, inching closer towards the Federal Reserve’s dual-mandate objectives of maximum employment and price stability. While the jobless rate is still a little above the median of FOMC estimates of its longer-run level, further employment gains may well help support labor force participation as well as wage gains. Meanwhile, US economic growth appears to have picked up from its subdued pace earlier this year. After rising at an annual rate of just 1% in H1 FY16, inflation-adjusted GDP is estimated to have increased nearly 3% in Q3 FY16. In addition, consumer spending has continued to post moderate gains, supported by solid growth in disposable income, upbeat consumer confidence, low borrowing rates, and the ongoing effects of the rise in household wealth.f3f4

The rate increase was only the second in Yellen’s nearly three-year tenure as Fed chair, underscoring her strategy of gradualism in the FOMC’s policy decisions. The unemployment rate was 6.7% when Yellen took office in February 2014, and it is now at 4.6%. Overall, the FOMC continues to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain maximum employment and price stability.

Trump’s proposals to spur inflation

President-elect Donald Trump’s economic team has announced a goal of 3% to 4% growth fueled by a mix of tax cuts, fiscal spending, and deregulation. Trump has pledged as much as $1 trillion in infrastructure investment and defense spending as well as cuts to corporate and individual income taxes, aimed at spurring economic activity and inflation. However, any dismantling of foreign trade agreements or imposition of import tariffs would be expected to hurt the US economy. US tech firms, most of which make their products overseas, could bear some of the brunt of any new trade restrictions.

In the coming months, it remains to be seen how Fed officials respond to Trump’s new economic policies and a new regime of faster growth and stronger inflationary pressures. For now, Yellen stated that gradualism will continue to anchor their strategy for 2017 as the Fed adopts a wait-and-watch approach to the market reaction after the rate hike.

Near-term outlook

Even as President-elect Donald Trump prepares to take office on January 20th, 2017, Yellen reiterated that she intends to serve out her full four-year term as Fed chair that expires in February 2018. Meanwhile, Fed officials have reiterated that near-term risks to their outlook are roughly balanced, while projecting three quarter-point rate increases in 2018, based on median federal funds forecasts of 1.375% in 2017 and 2.125% in 2018.

Encouragingly, policy makers see GDP growing 2.1% in 2017, up from a previous forecast of 2%, while slightly reducing their outlook for unemployment to 4.5%. The median projection for the longer-run federal funds rate increased to 3%, a small shift from about 2.9% in September 2016. The focus now shifts to the Fed’s meeting on January 31st and February 01st, 2016, in Washington, and on March 14th-15th, 2016 to assess the economic scenario post the rate hike.

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