AFI’s Outlook on Fed Interest Rate Policy
For those who might have missed it, the Federal Reserve Open Markets Committee raised its target funds rate on June 14, 2017 from 1.00% to 1.25%. This was the third rate hike since December 2016 and the fourth since December 2015. The current prediction is there will be two additional rate hikes this year.
The Fed has wanted to raise rates, and with the improving economy it finally has had its chance. One advantage to having higher rates is that if (when) there is another pull back in the economy, the Fed then has the ability to lower rates to re-stimulate the economy. Prior to the rate hike in December 2015 the Fed had gone seven years without raising rates which forced them to use other means to try massage the economy. The Federal Reserve also has a balance sheet (bond assets that it has bought) of $4.4 trillion (it had been a steady $800 million prior to September 2008) that it would eventually like to reduce back to historic levels.
Board of Governors of the Federal Reserve System (US), All Federal Reserve Banks: Total Assets [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WALCL, July 6, 2017.
The ability of the Fed to continue to raise rates and reduce its balance sheet is predicated on the continued improvement of the economy. Typically as the economy improves we see higher inflation, and the raising of rates helps to mitigate any rampant inflation. The unusual aspect of our current situation is that even with the entire stimulus we have not been able to see much movement in inflation. The thinking of the Fed is that they are working to stay ahead of inflation, and while they may be doing that, we are not seeing many signs that multiple rate hikes over a number of years will be necessary.
With our Federal Reserve raising rates, the actual rates on US Treasury bonds are not changing much. This may be the result of US rates being much higher than other developed nations who are further behind us in their recoveries from the 2008-2009 recession. Since interest rates in Germany, Japan, and the UK, for example, are so much lower than ours, many of the institutions and individuals in those countries continue to buy our Treasury bonds for both safety and a higher yield which keeps our pricing down. This will not continue forever, so volatility may return and return quickly at some point.
As the summer moves into fall we may get better clarity on the potential of the US economy, and we’ll see if the Fed is able to continue its desired, carefully-measured rate increases.