The Federal Reserve did not throw markets a curveball on Wednesday, choosing to increase the federal funds target rate for the first time in nearly 10 years. The voting members of the Federal Reserve Open Market Committee (FOMC) approved the decision unanimously in a 10-0 vote.
After an unprecedented era of interest rates near zero, the first liftoff since 2006 moved the target federal funds rate from the 0-to-0.25% range a quarter-percent higher to 0.25-to-0.50%.
The move was a surprise to very few after literally a year of speculation as to when the Fed would raise rates. However, that didn’t stop Federal Reserve Chair Janet Yellen from issuing dovish statements regarding the future plans of the central bank.
The FOMC statement and Janet Yellen’s post-meeting press conference indicated that the Fed expects to make just two to four more rate hikes in 2016. This comes much closer to one rate hike every other month, or even every three months, rather than consistently raising rates each month.
The Fed seems to have heeded the markets’ concerns that a rapid series of rate increases would throw the economy into turmoil. Such a dramatic move would have far-reaching effects on the financial markets due to the higher interest. It would force banks to suddenly tighten their lending, severely limiting access to credit. The drying up of lending would make it very hard to conduct business. At the same time, however, interest rates that became significantly higher all of the sudden would dampen the outlook for gold. (There is a higher opportunity cost of holding gold the higher interest rates are.)
Hopefully, a gradual rate hike pace will help smooth out these speed bumps along the way.
Order of Operations
Much has been made about how the Fed has never raised rates when its balance sheet was so big. (Moreover, its balance sheet—total assets minus liabilities—has never been this big.) Some have suggested that the Fed should’ve been cutting its balance sheet before engaging in rate increases. While this would be better in theory, it’s probably more trouble than it’s worth for the Fed to scramble to sell assets before starting the path to normalization. It’s even true that most central banks maintain a much larger balance sheet as a proportion of GDP than the Fed does.
If the Federal Reserve sticks to its projection of one rate hike per quarter in 2016, it means that the year-end federal funds rate will be right around the 1.375% range. Something important to keep in mind, of course, is that the Fed has avoided telegraphing the “when” and “how much” of its rate hikes. It can use this ambiguity to space out its moves as well as break them into smaller increments. While this is probably good for the Fed to have such flexibility, it doesn’t engender great confidence in market participants and traders that would ideally like to know these details. However, the ambiguity is also a way to keep opportunistic traders from reaping benefits from foreknowledge of the timing and size of rate hikes.
The opinions and forecasts herein are provided solely for informational purposes, and should not be used or construed as an offer, solicitation, or recommendation to buy or sell any product.