The Federal Open Market Committee (FOMC), the Federal Reserve's interest rate-setting panel, voted unanimously on Wednesday to raise the federal funds rate by 0.25 percentage points to a target range of 0.50% to 0.75%. According to a statement released at 2:00 p.m. EST, the committee based its decision on solid job gains and a moderate pace of economic expansion since mid-year. It noted that, while household spending has risen moderately, business fixed investment remains soft. Inflation remains below target, and monetary policy remains slightly accommodative, based on the judgment that the neutral real rate – the rate that encourages neither expansion nor contraction – remains "quite low by historical standards."
The Fed projected three interest rate hikes in 2017, compared to previous forecasts of two hikes.
Wednesday's tightening, the first since December 2015 and only the second since 2006, was widely anticipated: the CME Group's FedWatch tool, which tracks fed funds futures, put the probability at 92.9% as of 12:55 p.m. The market reaction has accordingly been muted. The S&P 500 index popped to an intraday high of 2,276.75 within minutes of the release, then quickly slumped to 2,264.75 as of 2:24, 0.3% below Tuesday's close of 2,271.72. Equities often respond negatively to rising rates, though markets can take rate rises as a sign of confidence in the economy. The U.S. dollar index has risen 0.5% to 101.55 as of 2:28. A measure of the dollar's strength against of other currencies, it can be expected to benefit from inflows of capital to higher-yielding U.S. assets.
An exception to the generally understated market reaction is the 10-year Treasury yield, which rose by around 0.06 percentage points to nearly 2.53%, its highest level since September 2014.
The question on everyone's mind is what comes next: a sustained rise in interest rates, or more of the same? The answer may lie in the Fed's updated projections, released in conjunction with the rate decision. On the other hand, rate projections have been overly gung-ho in the past, with the actual interest rate trajectory falling well short.
ZIRP and NIRP
Before trying to divine where rates are going, it's worth looking at where they're coming from. Beginning in September 2007, the Fed slashed rates in response to the unfolding mortgage crisis, reaching the ostensible bottom, a target range of 0.00% to 0.25%, in December 2008. So-called zero interest rate policy (ZIRP) reigned for fully seven full years, and seven central banks – beginning with Sweden in July 2009 – have shown that zero is not, in fact, the bottom by introducing negative interest rate policy (inevitably, NIRP) to 25 nations.
Not pictured: Bank of Japan's short-term policy interest rate of -0.1%.
It is difficult to gauge the success of the low rate regime, since the terrible crises that might otherwise have occurred remain hypothetical. However, it is easy to see the pain it has caused in Europe's drowning banks, savers whose deposits yield nothing, and bond investors who must pay to lend to dysfunctional governments. According to critics, the main beneficiaries of low rates have been large companies and wealthy individuals, who can borrow cheaply. Nor has the result necessarily been productive investment. A record proportion of fund managers surveyed by Bank of America Merrill Lynch (BAML) in early December – net 74% – thought companies were under-investing. A common use of borrowed funds has been to buy back shares.
Many, including President-elect Donald Trump, are calling for the Fed to pick up the pace of rate hikes. The future path of rates depends on a number of factors, most of them unforeseeable. Politics will play a role, since Trump will be able to fill two of the twelve FOMC's voting seats when he takes office and chose a new chair to replace Janet Yellen in early 2018 (Yellen reiterated her intention to serve out her term Wednesday and left open the possibility that she would retain her board seat after stepping down as chair). At least as important, though, are data related to growth, inflation and unemployment.
The Fed has a statutory requirement, often referred to as the dual mandate, to seek maximum employment and stable prices while maintaining moderate long-term interest rates. While critics joke that the Fed has taken on a third mandate – keeping either markets or politicians happy, depending on the source – the FOMC says it takes two main data sets into account when making interest rate decisions, inflation and unemployment. It also projects gross domestic product (GDP) growth, which is tightly linked to both of these variables, and the future path of rates. The Fed issued updated quarterly forecasts for these data points Wednesday.
The first data point the Fed forecasts is unemployment. "Maximum employment" is not precisely defined, but the FOMC has generally identified it with an unemployment rate of 4.5% to 5.0%. At 4.6% in November, the current rate is the lowest since August 2007. It falls comfortably within the "maximum employment" range and below the Fed's long-run estimate of 4.8%, which has remained constant since March.
The Fed reduced unemployment forecasts by 0.1 percentage point to 4.5% for 2017 and 2019, leaving the 2018 forecast of 4.5% intact. Yellen fielded questions Wednesday regarding earlier statements she made suggesting that the economy could benefit from "running hot," with a tighter labor market leading to higher inflation. She denied that she was planning on running an "experiment" by allowing competition for workers to drive up inflation. Meanwhile she commented that labor market slack had largely dissipated, yielding tight conditions similar to 2007.
Note: FOMC materials describe the "longer run" as "maybe in five or six years – in the absence of further shocks and under appropriate monetary policy."
The second data point is inflation. The Fed prefers to use the Personal Consumption Expenditures (PCE) index, and while it tracks changes in the broad PCE index, it focuses on changes to core PCE, which excludes the volatile food and fuel components.
Even as labor market conditions have improved to where they are well within the Fed's target range, annual core PCE inflation has remained stubbornly below the Fed's target of 2.0%, due in part to collapsing energy prices. Core PCE rose 1.7% year-over-year in November, the fastest rate since January 2012. According to the Fed's latest projections, it is expected to hit 1.8% in 2017 and 2.0% in 2018 and 2019. These forecasts are unchanged from September.
The lack of revisions to inflation projections may come as a surprise, since market indicators have pointed to rising levels of inflation following Trump's election victory. Rolling eight-week inflows to Treasury inflation-protected securities (TIPS) hit record levels in the days after his win, according to BAML. 10-year Treasury yields also surged, leading to a steeper yield curve, both of which are indications of a higher inflation.
Yellen mostly evaded questions regarding Trump's plans for fiscal stimulus, which have stoked inflation expectations. She said she could not comment on policies for which specifics were not yet available and that she did not want to be perceived as offering advice to the incoming administration or Congress.
The Fed raised estimates for 2017 and 2019 real GDP growth by 0.1 percentage point each, to 2.1% and 1.9% respectively. It left its 2018 estimate of 2.0% intact, as well as its long-run estimate growth estimate of 1.8%. During the campaign Trump promised growth of 4%, 5% and even 6% per year.
Federal Funds Rate
Based on its growth, unemployment and inflation forecasts, the Fed projects the future trajectory of interest rates. The Fed now projects three 25 percentage point rate hikes in each of the next three years. In September it forecast two hikes in 2017, three in 2018 and three in 2019.
Note: the values above are based on the midpoint of the target range, so that a range of 0.50%-0.75% would be shown as 0.625%, rounded to 0.6%.
After eight years of accommodation, hawks are expressing worries that the Fed is already "behind the curve" – as a reporter at Wednesday's press conference put it – in tightening monetary policy. Yellen responded that the degree of accommodation following the most recent hike is "moderate," since neutral rates remain low. She pointed out that inflation is projected to undershoot for a couple of years and that there is no evidence of labor shortages leading to "rapid inflation."
Will the Forecasts Pan Out?
First, it's important to note where these forecasts come from. They are based on the individual assessments of the members of the Board of Governors and the 12 regional Fed presidents, the FOMC's "participants." Confusingly, this group is not the same as the FOMC's voting members, who actually set interest rates. Under normal circumstances, there are seven governors, but there are currently two vacancies. Each of the governors gets a vote on the FOMC, as does the president of the New York Fed. At any given time, four of the remaining 11 Fed presidents get a vote; they rotate on an annual basis.
As a result, economic forecasts reflect the outlooks of 10 voting members and seven non-voting ones, with no way of knowing for sure what effect non-voting members' opinions are having on the forecasts. This conundrum is most evident in the "dot plot," a tantalizing graphic that shows individual participants' views on the appropriate path of rates, but does not label the dots. As a result, it's impossible to know for sure – though people do guess – when the dove calling for 0.875% in 2019 or the hawk calling for 3.375% in 2018 will be able to cast a vote.
The December 2016 "dot plot": each point represents, to the nearest eighth of a percentage point, the opinion of an FOMC particpant regarding the appropriate federal funds rate (midpoint of the target range) at the end of a given year and in the "longer run." The dots are anonymized.
The disconnect between the ones doing the forecasting and the ones doing the voting may explain the disconnect between the forecasts and the reality. The Fed's projections for future interest rates, at least since the crisis, are chronically over-eager. In December 2013, FOMC participants gave a median forecast of 1.75% for the fed funds rate at the end of 2016. By December 2014 the forecast had risen to 2.5%, even though the rate itself had remained stubbornly in ZIRP territory in the intervening twelve months. By December 2015, reality had intervened in the form of China's currency devaluation, which spawned an ETF flash crash and months of ensuing market turbulence: the forecast for the end of 2016 fell to 1.375%, more than double the rate we're poised to finish 2016 with (going by the midpoint of 0.625%).
In short, don't put too much faith in projections.