The Federal Reserve on Wednesday moved as expected, raising the federal funds target rate by 25 basis points and sending clear signals that it believes the economy is growing — albeit, slowly — as labor market conditions improve.
The central bank’s decision also suggests the Fed will keep course on its plans to increase rates one more time this year and three times in 2018. In an optimistic statement, Fed officials noted that job gains were moderate but solid, unemployment dropped and household spending picked up.
The hike, which increases borrowing costs and affects credit cards and home equity loans, is the second by the Fed this year, but just the fourth increase in the nine years since the financial crisis. The move happened despite the fact that inflation has been relatively benign and continues to fall short of the Fed’s 2 percent target.
During a news conference with reporters, Fed Chair Janet Yellen said the hike reflects the economy’s progress, and that a steady approach to future rate increases is the best way to avoid damaging the economy.
“We want to keep the expansion on a sustainable path and avoid the risk where…we need to raise the funds rate so rapidly that we risk a recession,” she’s quoted as saying in The Washington Post.
There was little doubt the central bank would increase rates, leaving markets to focus on how the Fed would address its balance sheet, which has swelled to $4.5 trillion as a result of quantitative easing. That program was a bonds-buying measure to stimulate the economy by pushing down long-term interest rates to ultimately lift the economy from the financial crisis.
For months, speculation prevailed that the Fed would seek to trim the balance sheet — its collection of securities and Treasury debt — by almost half, cutting it down to about $2 trillion. If the Fed fails to slash it, the result could be higher inflation and higher interest rates.
On Wednesday, officials unveiled a plan that would gradually allow its assets to roll off, starting with up to $6 billion in Treasurys and $4 billion in mortgage-backed securities. These caps will increase every three months until they hit $30 billion for Treasurys and $20 billion for mortgage-backed securities.
That will, in the words of policymakers, reduce its quantity of reserve balances to a level “appreciably below” what it’s been in recent years but larger than what it was before the financial crisis.
We will need to watch this play out in time as these activities will have an incremental increase to longer term rates if executed to perfection. Of course, many things can happen that can move markets in a variety of ways so this will be interesting to see how it all plays out.
Inflation measures a little weak
Also holding the market’s attention this week were the Producer Price Index and Consumer Price Index, two key gauges of inflation that give us insight into the likelihood of a Fed rate hike come September.
Before we get into the weeds with these, let’s explore what these data actually mean.
- Consumer Price Index: This measures the change in the average price level of a fixed basket of goods and services purchased by consumers. It shows the change in price levels since the index base period, currently 1982-84= 100. Monthly changes in the CPI represent the rate of inflation.
- Producer Price Index: This grouping of indexes measures the average change over time in the prices received by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.
Both are critical inflationary reports the Fed will consider when it reconvenes in three months.
On Tuesday, the Producer Price Index was relatively unchanged as energy costs fell to their lowest levels in nearly a year. Ahead of the Fed’s meeting Wednesday, the Labor Department released the Consumer Price Index, which showed that U.S. consumer prices fell by 0.1 percent, short of the 0.2 percent increase analysts expected.
Retail sales were also weak, dropping 0.3 percent in May against the 0.1 percent increase forecasted. The report from the Commerce Department was mixed as officials revised April’s readings upward.
The numbers demonstrate that inflation has been relatively soft and could deter the Fed from proceeding with a rate hike in September if it feels the market is unable to bear the squeeze of tighter spending.
Why a rate hike?
The Fed’s primary mission is to regulate monetary policy, spur maximum employment and create a stable rate environment that will keep inflation and economic growth under control. Its main modus operandi is to adjust the benchmark interest rate to achieve a happy medium in the economy.
Rate hikes, which make it more expensive to borrow money, can be the solution to keeping this phenomenon in check, and shouldn’t be treated with any trepidation.
The inflation sweet spot is 2 percent, and the Fed plans to raise rates at least three times in 2018 to achieve that target. Despite the trend of shaky inflation, the forecast for 2018 and 2019 was unchanged.
Market reaction to all the news
Following the Fed’s decision, inflation and retail sales data, among several other economic indicators this week, continued the trend of coming out softer than expected and will keep a lid on longer term rates for the foreseeable future. We will be in a flatter yield curve environment for a while until the economic data comes in stronger and starts putting upward pressure on longer term rates. The 10 year treasury one month chart below reflects the grind lower in yields to near yearly low of 2.16 percent.