United States: Fed finally pulls trigger on rate hike after months of building expectation
December 17, 2015
At its 15–16 December policy meeting, the Federal Reserve’s Open Market Committee (FOMC) announced that it would finally be raising interest rates after having kept them at historic-lows since just after the global financial crisis hit in 2008. The FOMC is increasing the Federal Funds Target Rate by 25 basis points to a range of between 0.25% and 0.50%. The majority of market analysts were expecting the move as numerous Fed officials, including Chair Janet Yellen, had recently signaled confidence in the growth trajectory of the economy. The Fed has had its finger on the trigger throughout the second half of the year, although lingering concerns over the health of the domestic economy and unsettling global developments had kept them from making a move in previous meetings. However, steady improvements in the U.S. economy in the past months, particularly in the labor market, and a growing risk of losing credibility prompted the Fed to open a new chapter in its policy making in December.
The Fed’s latest accompanying statement contained several meaningful changes. The Fed reiterated that the economy has continued to expand at a moderate pace, but emphasized that a range of indicators reflect considerable progress in the labor market. Moreover, the reference to volatile global and financial developments was removed and monetary officials pointed out that the risks to the outlook for economic growth and the labor market are now balanced. Overall, the accompanying statement comes across as more confident and contrasts the sense of concern exhibited previously. The Fed expects GDP to expand 2.5% in 2016 after a projected growth rate of 2.1% in 2015.
In terms of price developments, the Fed acknowledged that inflation continues to run below its longer-run target of 2.0% and that inflation expectations have edged down. However, the Fed still expects inflation to rise towards this objective over the medium term as the effects of lower energy and import prices dissipate and as the labor market gathers more strength. Committee members’ project that inflation will range between 1.2% and 1.7% in 2016 and increase to between 1.8% and 2.0% in 2017.
Given mounting evidence of ongoing economic recovery and confidence that inflation will rise going forward, the Fed decided to implement a small but significant interest rate hike. The Fed explained that it will take time for such a policy action to have an effect on the economy, but presumably decided to make a move before it was too late. Analysts have pointed out that higher rates should help avoid bubbles building up in the economy and that the Fed will need maneuvering room to bring rates back down in the case of an unexpected economic slowdown in the coming years. Moreover, despite the hike, monetary policy still remains highly accommodative and will continue to support the economy.
Looking forward, additional rate hikes are expected although implementation will undoubtedly be very gradual. The Fed emphasized that the timing and size of further adjustments will depend on actual and expected economic developments. In the follow-up press conference after the meeting, Janet Yellen explained that the Fed does not have a fixed calendar in mind or a mechanical formula to determine the pace of subsequent rate hikes. In a supplementary document released after the meeting, the median projection for the Federal Funds Rate at the end of 2016 is 1.4%, which implies four 0.25% rate hikes. The rate is projected to be at 2.4% by the end of 2017, which is down from the 2.6% predicted in September.
Author: Carl Kelly, Economist