Dec. 17, 2015, Federal Open Market Committee Announcement Review

 

As anticipated, the FOMC announced yesterday that the target federal funds rate of 0.0% to 0.25% will rise to a range of 0.25% to 0.50%. With this increase, the first since 2006, the financial world will shift its focus from “When?” to “Next?” The press release issued with this decision indicates that FOMC members will watch a wide range of economic factors to measure the impact of this change and the release makes no comment pointing to further increases in the near future. As noted by Chair Yellen at a recent JEC hearing, any further increases will be implemented gradually and will be supported by data.

 

Note: Median projection; Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents

 

Context

Across economic indicators, the recovery remains uneven.

• Projections for 3%+ GDP growth have all but disappeared, and fourth quarter GDP is expected to keep near the third-quarter trend of 2.1%. The Atlanta Fed currently estimates real GDP growth for the fourth quarter to be 1.9%. Forecasts for a mild winter in 2016 indicate that the economy will avoid weather-induced 0.6% GDP growth seen in the first quarter of 2015.
• Although more economists expect slow but steady U.S. GDP growth, many still worry that global economic weakness could impact our economy. Further, the strong dollar is weighing down exports, harming the manufacturing and agricultural sectors, and the FOMC rate increase will keep the dollar value high.
• The unemployment rate is down to pre-recession levels, at 5.0% in November. However, the labor force participation rate of 62.5% remains near post-recession lows. The “real” unemployment rate of 9.9%, which includes the unemployed, workers marginally attached to the labor force, and part-time workers seeking full-time jobs, remains more than 1.5 percentage points above pre-recession levels. 
• The average 2% GDP growth rate has yet to show up in equivalently higher wages. Real hourly compensation achieved small gains over the last year. A newly released Pew Research Center study shows middle-class jobs shrinking broadly across most industries except agriculture, mining and repair services. 
• Inflation is below the FOMC’s 2% target rate, and Fed economists do not expect it to reach target until 2018. An unexpected inflation spike could upend investor expectations.

Expectations Going Forward

The Fed statement released yesterday affirmed that the economy continues to expand at the “moderate pace” noted at its last meeting, with the housing sector improving further. The statement reported that the labor market has seen “considerable improvement” and the outlook for both the economy and the labor market is “balanced.” However, during the press conference following the FOMC decision, Chair Yellen declared that the labor market had not fully recovered. The Fed notes that it will continue to monitor the situation abroad, as net exports are soft. Although inflation is below its target, this is attributed to drops in energy and import prices during 2015. The FOMC will monitor inflation, but expects a “medium term” return to 2%. FOMC members voted unanimously in support of yesterday’s increase.

The “dot-plots” show that FOMC members see the economy strong enough to support a target-range fed funds increase of 50 basis points or more to between 1% and 1.5% in 2016, with further rises in 2017 and 2018.

DOT-PLOTS: FOMC Members Target Range for Fed Funds Rate

Source: Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents

 

The Bigger Picture

Rates have never been kept this low for so long, so there is no past track record to anticipate how the economy would react to a return to pre-intervention rate levels. The possibility of a Fed rate rise in 2013 caused a market reaction that pushed financial markets down and interest rates up. This 2013 experience has motivated the Fed to message its actions well in advance and seek to base its decision on economic data – although some observe that this rate hike is happening despite mixed data.

 

The impact of the FOMC action on savings deposits, mortgages and consumer loans is unclear. Some worry that higher mortgage rates could slow down the real estate recovery. Most financial experts believe borrowing rates will rise faster and higher than deposit interest rates paid to savers. Immediately following the FOMC move, Wells Fargo raised its prime lending rate but made no change to interest it pays on deposits.

 

There is still plenty of speculation as to how the Fed plans to deleverage the assets it has accrued over the course of the recession and into the recovery. As of October 28, the Federal Reserve balance sheet reported total assets of $4.5 trillion, up slightly since July 29.

 

Asset reduction may be a long time away. In her December question and answer session during a JEC hearing on the Economic Outlook, Chair Yellen expressed a willingness to increase Fed assets as a monetary tool. Yesterday’s announcement included no action to reduce Fed assets, and Chair Yellen made no commitment to shrink the Fed balance sheet during the press conference following the FOMC decision.

It should be kept in mind that a rise in rates brings with it higher service payments on the federal debt, which currently tops $18 trillion. According to the latest update to the Budget and Economic Outlook: 2015 to 2025 released in August, the Congressional Budget Office (CBO) expects the Federal Reserve to raise rates to roughly 0.2% in the final quarter of 2015, to 2.4% in the final quarter of 2017, and 3.4% by the second quarter of 2019. As such, the CBO projects 3-month Treasury bills will rise from nearly zero to 2.2% by the end of 2017. Compared to its March estimates, “CBO reduced its projection of net interest costs for the 2016-2025 period by $324 billion, almost entirely because of changes to projected interest rates.” Alternatively, as the CBO noted in its January release of the report, if interest rates on all types of Treasury securities were 1 percentage point higher each year through 2025 than projected, and all other economic conditions equal, the projected incremental amount of deficit increase over the decade would amount to $12 billion in 2015, $198 billion in 2025, and total nearly $1.7 billion over ten years: