After more than nine years, on Wednesday, the Federal Reserve of the United Stated made true to its promise of raising interest rates in 25 basis points moving from near zero to the range of between 0.25-0.5%. It also stated it would not shrink its balance sheet until rate normalisation was ‘well under way’. Though policy remains extraordinarily accommodative, this is the first small step toward interest rate normalization since the financial crisis.
Markets took the Fed’s hike very much in their stride. 2-year yields rose by 2 basis points to 1.00%, but 10-year yields were a touch softer at 2.29% at the time of writing. The dollar inched higher against the euro, yen and on the Bloomberg DXY basket. While stocks reacted to the message of the Fed’s confidence in the economy the S&P 500 index rose 1% to 2074.
What will happen next? The Fed continues to project an expectation of four rate hikes next year, describing these as gradual, with no fundamental shift in its other economic projections to signify a more dovish outlook than in September. But, according to David Page, Senior Economist at AXA Investment Managers (AXA IM), this means that «the Fed failed to deliver a ‘dovish hike’. We continue to expect a tightening in financial conditions to lead the Fed to deliver just three hikes next year. Yet financial markets took today’s move in its stride, with little today deviating from broad expectatios…we consider the likelihood that the Fed has seen insufficient evidence of inflation pressures to justify a move in March and we forecast the next move in June.»
Goldman Sachs Asset Management said that they think the Fed’s action amounts to a cautious hike, and that «based on current forecasts, we believe the trajectory of interest rates will be shallow. Given the positive trends in the US labor market, we expect the Fed’s main focus in the coming months will be on inflation, financial conditions—particularly dollar strength—and economic growth.» They also expect three hikes in 2016 but «We believe the Fed could raise interest rates again in March if inflation rises and financial conditions stabilize. Our current expectation is for an additional three increases in 2016, but the path remains uncertain.» They cited that the dollar’s strength was among the key factors—along with broader financial conditions and weak external demand—in the Fed’s decision to postpone tightening in both June and September this year.
In regards to the Fed’s announcement of a modification of its balance sheet policy -suggesting that it would not stop or taper reinvestment of maturing Quantitative Easing (QE) assets until normalisation was ‘well under way’ (previously it had simply said this would start after lift-off), Page commented that » this was a clarification that we had long anticipated and echoed a similar recent statement by the Bank of England.»
Fed Chair Yellen’s press conference did little to overtly suggest a more dovish assessment. She was questioned on the inflation outlook and repeated that actual progress was required, but refused to be pinned down on any metric or timeframe of such an assessment. She highlighted the FOMC’s assessment that risks were balanced. The Fed Chair provided the Fed’s justification for a hike, which having fulfilled the conditions posed by the Fed was broadly to avoid the risk of the need for a future abrupt tightening, which she said might increase the chances of prompting recession. She also emphasised that the Fed’s policy outlook was for an expectation of gradual tightening and one that would likely not be even-paced.
Economic forecasts saw little change:
- the median estimate of Q4 year on year GDP was nudged higher to 2.4% from 2.3% in 2016, but were otherwise unchanged;
- unemployment was forecast marginally lower at 4.7% from 2016 onwards (from 4.8%);
- and headline and ‘core’ personal consumption expenditure (PCE) inflation was forecast marginally lower to 1.6% (from 1.7%) in 2016, but was otherwise unchanged.
- Longer run estimates of the these factors were unchanged.
- Moreover, the Fed saw little adjustment in the median estimate of future rates, although some of the higher forecasts were lowered.
GSAM agrees saying that they «do not believe this modest policy adjustment is likely to derail a US recovery that has momentum. As a result, we remain pro-cyclical in our investment outlook, with equities remaining our favored asset class at this stage of the cycle.» Although their growth expectations are slightly lower, moderating from 2.4% this year to 2.2% in 2016.»
«In emerging markets, we think commodity prices, Chinese growth and local fundamentals are more important than Fed policy. Markets have had a long time to adjust to the prospect of higher US rates and we believe emerging market assets have largely priced in a modest course of Fed tightening. As a result, we continue to believe emerging market assets will be driven primarily by local fundamentals,» concluded GSAM.