On 16 December 2015 the Federal Open Market Committee (FOMC) took the historic step of raising the target range for the federal funds rate for the first time since the financial crisis.
The Committee will now seek to keep the daily effective federal funds rate between 25 and 50 basis points, 25 basis points higher than the prior target range.
There were a number of interesting cross-currents in the communications released by the Federal Reserve, but on the whole there were no major surprises relative to market expectations.
Overall, the policy statement and Chair Yellen’s press briefing leant in a dovish direction. The Committee incorporated forward guidance into the statement, noting that it expects “economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate”. In addition, in an echo of language used in the Chair’s early December speech, the statement noted the shortfall of inflation from 2% and that “the Committee will carefully monitor actual and expected progress toward its inflation goal”. When asked during the press briefing to clarify what this language implies about the Committee’s reaction function, the Chair noted that should inflation not conform to their expectations, “that would certainly give us pause”. So while “reasonable confidence” in inflation moving back towards 2% was a sufficient condition for lift-off, the Committee will now be looking for validation of their expectations in the data. Higher inflation is not a precondition for each hike, but signs that inflation is not conforming to expectations would certainly lead to a pause in policy normalization. Finally, the Committee decided to delay any change to the size of its Treasury and Mortgage-backed Securities (MBS) portfolio until policy rate normalization is “well under way”. This means that investors will not need to contend with additional Treasury and MBS supply being added back into the market until the second half of 2016, and possibly not until 2017.
The Summary of Economic Projections (SEP) revealed few changes in the Committee’s macroeconomic projections. Relative to the September SEP, the median projections imply marginally stronger expectations for GDP growth and the labor market in 2016 – the median participant now projects the unemployment rate falling by an additional tenth of a percent in 2016, to 4.7 %. This slightly improved outlook for the labor market may explain why the median Committee member’s policy rate projection for the end of 2016 did not come down at all, despite a somewhat softer inflation profile. An unemployment rate that is now expected to fall further below the Committee’s NAIRU estimate by the end of next year is consistent with greater confidence in the longer-term inflation outlook.
Further out, the median projections for policy rates came down a bit, by 20 basis points in 2017 and 10 basis points in 2018. The median path of policy rates now reflects 100 basis points of policy tightening each year, which is how investors will likely come to interpret “gradual increases in the federal funds rate”. Still, the Chair emphasized in her press briefing that the term should not be confused with “mechanical”, “equally-spaced hikes”. This reflects the primacy of data, particularly the evolution of inflation developments, for future interest rate decisions.
The Committee has to be extremely pleased with the market reaction after their communications, as financial conditions did not greatly change. Ten-year Treasury yields ended essentially where they were just before the policy statement and SEP were released, the dollar index rose only modestly, and stocks finished higher. So for the time being at least, markets have heard loud and clear the message of a gradual pace of interest rate increases, with the Committee very attuned to incoming data related to inflation. Still, there remains a considerable gap between market expectations for the path of the federal funds rate, and the median policy rate projection in the SEP. With oil- and dollar-related base effects likely to lead inflation higher early next year and few signs of the labor market losing momentum, an additional interest rate increase in March is a distinct possibility. “Gradual” is a calming term for the time being, but markets may soon need to discount a steeper path of policy rates, one that is more consistent with the Committee’s projections.