The Independent Market Observer

Fed Holds but Hints at December Hike

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Sep 22, 2016 11:53:37 AM

and tagged In the News

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FedTo no one’s surprise, the Fed decided not to raise rates yesterday. At the same time, however, it managed to hint about as strongly as it ever has that a rate increase is coming by the end of the year.

This is the kind of messaging that has historically preceded action, so December is looking very likely. Markets are now pricing in a more than 60-percent chance of a rate hike in December.

The real pressure for the Fed to start increasing rates looks to be internal. The economic data does support a hike, and it has for some time. What’s different now is that 14 of 17 Fed officials want at least one rate hike by the end of the year, and 3 of the 14 felt strongly enough about it to dissent from the decision to keep rates stable. For the Yellen Fed, that level of dissent is very unusual, and the weight on the side of an increase suggests that it has become the default decision for December.

After the first hike, moderate increases

Beyond December, though, the Fed is still dovish. Although faster rate increases remain on the table, the expected end point is now only around 2.9 percent, well below past peaks, and the expected level at the end of 2018 is around 1.9 percent, down from 3.4 percent last September. Though a rate increase is probably coming, there shouldn’t be too many more after that.

This shift appears to reflect two main factors: low U.S. growth and the risks associated with starting to tighten while foreign central banks continue to ease. With U.S. growth low and looking likely to remain that way, the Fed simply doesn’t have the headroom to raise rates to levels that we had in the past. With foreign banks continuing to ease, tighter U.S. policy could put us at a disadvantage and hurt growth even more than expected.

Combined, these two factors tie the Fed’s hands on the upside, even as strong employment growth and rising inflation push it to act.

Markets seem to like the plan

Long story short, expect a rate increase in December and perhaps one or two next year. Absent accelerating growth, however, we probably won’t see much more than that. Though such a pickup remains possible, it is no longer the base case, and the Fed and financial markets are recognizing that.

For markets, as we saw yesterday, lower for longer is perceived as good news. With the strong hint about December, markets are clearly on notice, but the lower growth and interest rate projections show that, on balance, the Fed’s revised policy stance is considered positive.

The Fed has set the stage to start increasing rates at a moderate pace in the near future, and it has the ability to modify that pace according to what the data says over time—in other words, more or less exactly what it was trying to do. Not a bad day’s work.

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