Fed Surprises Financial Markets, Indicating 3 Rate Hikes Next Year

The biggest impact was on the dollar, which soared while stocks rose, then fell, and Treasury yields increased

At its last policymaking meeting for the year, the Federal Reserve raised interest rates on Dec. 14 for the first time in 12 months and, to the surprise of the market, indicated it could raise rates three more times in 2017, not the two times the market had expected.

The FOMC increased its short-term federal funds rate by 25 basis points to a range of 0.50% to 0.75% “in view of realized and expected labor-market conditions and inflation,” according to the Fed’s statement. More importantly, it raised its fed funds rate projections to a median 1.4% in 2017, up from 1.1%, indicating a third rate rise next year instead of the two that it had projected at its September meeting.

When asked in her press conference following the decision why Fed policymakers raised its expectations for rate hikes from two to three next year, Fed Chair Janet Yellen noted the change was due to a few factors: a lower projected unemployment rate – now 4.5% instead of 4.6% – and a “slight upward revision to inflation.”  

She said the change was a “very modest adjustment” that involved changes by only some Fed participants, indicating that this was not “a wholesale change” in outlook, said Karissa McDonough, fixed income strategist at People’s United Wealth Management.

Market reaction to the Fed decision was mixed. The Dow Jones industrial average initially rose modestly then reversed, falling more than 100 points to near 19,800 by 3:30 p.m., and the 10-year Treasury yield rose to 2.53%.

The biggest move was in the U.S. dollar. The U.S. dollar index soared to 101.76, from 101 at the previous close.

McDonough as well as Jack McIntyre, portfolio manager at Brandywine Global, and Roger Aliaga-Diaz, Vanguard chief economist for the Americas, all commented that the Fed’s projection for three rate hikes next year signal that the central bank is intent on controlling inflation longer term and not falling behind the yield curve as some analysts have been saying.

“Before the election, Yellen mentioned letting the economy run hot and the long end of the curve didn’t like that,” said McIntyre. “If the Fed is in a position to tighten three times, it wants to make sure inflation won’t get out of hand.”’

Given that analysis, McIntyre said the long end of the bond market “looks OK.”

McDonough favors bonds in the the three to five–year maturities with investors moving out on the yield curve as yields increase over time.

She said “the Fed is likely expecting fiscal policy will come in a much bigger way, providing leeway to normalize monetary policy."

When asked in her press conference about the potential impact of changes in fiscal policy including individual business tax cuts, which President-elect Donald Trump has championed, Yellen noted that tax policies can have an effect on productivity growth but it depends on the specifics. She said she couldn’t say how the Fed would react to any policy changes until it knows more details.

Tim Hopper of TIAA said the Fed’s move today – the second rate hike in a decade – exemplifies what the central bank has wanted to do for a while. Last year at this time the Fed also raised rates 25 basis points and indicated four rate hikes the following year but only did one, today. “Now the Fed is in a position where they will be able to raise rates next year,” said Hopper. “The difference between then and 2015 is that the economy now is performing better, moving in the right direction.”

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