Labor market improvement in 2015, which the Fed describes as “considerable,” is the key factor behind the move, as the other half of the Fed mandate—inflation—remains well below target.
Financial markets were expecting a dovish rate hike. While that term may sound like an oxymoron, the Fed’s dot plot—Fed members’ projections for the mid-point of the federal funds target range—was expected to be slightly lower than September’s.
For the end of 2016, the median target range mid-point is 1.375 percent—suggesting four more 0.25 percent rate hikes. That is unchanged from September. But in 2017 and 2018, the median target range mid-point is slightly lower than in September, reflecting the dovish Fed. At the end of 2017, it is 2.375 percent and at the end of 2018, it is 3.25 percent.
Wednesday’s rate hike itself is noteworthy, but in the grand scheme of things, the Fed’s guidance on the interest rates going forward is far more important.
“Monetary policy remains accommodative,” said Fed chair Janet Yellen in her opening remarks.
The key word “gradual” was used in the statement as a qualifier to “adjustments in the stance of monetary policy” and “increases in the federal funds rate.”
Leading up to the Fed decision, the U.S. 2-year bond yield reached 1.00 percent, its highest level in over five years. The yield rise quickened after the October Fed statement that strongly hinted at a December rate hike, which markets began pricing in.
And jobs data has largely supported the Fed’s thesis in the interim. Job growth has average 254.5K in October and November with the unemployment rate at 5.0 percent. The work on the jobs front is nearly done.
New median projections for the unemployment rate are for a slight drop to 4.7 percent from 2016 to 2018 before settling in at 4.9 percent in the longer run. Gross domestic product growth is projected at 2.4 percent in 2016 before slowing to 2.0 percent in 2018 and the longer run.
Inflation—or Lack Thereof
Low inflation remains a persistent problem, but the Fed is expecting it to reach the 2 percent target over the medium term.
On a year-over-year basis in November, the U.S. consumer price index rose 0.5 percent, but core prices, which exclude food and energy, rose 2.0 percent.
The projections for personal consumption expenditures (PCE) inflation are 0.4 percent for the fourth quarter of 2015, 1.6 percent at the end of 2016, and essentially reaching the 2.0 percent target in 2017. Those figures are roughly unchanged from September’s projections.
“Softness in inflation is due to transitory factors that we expect to abate over time,” Yellen said. Those transitory factors are the drop in oil prices and a strong U.S. dollar, which depresses import prices.
“I have been surprised by the further downward movement in oil prices,” Yellen admitted.
“There’s two sides of the decline in oil prices for the U.S.,” Bricklin Dwyer, an economist at BNP Paribas in New York tells Epoch Times. “Near-term is pain and obviously downward inflation pressures, but medium- to long-term, it means more spending and consumers have more money.
“And that means upward pressure on inflation, core inflation that is.”
Dwyer shed light on the “transitory” decline in oil prices. If it wasn’t transitory, oil prices would keep dropping forever. And that couldn’t be the case given the breakeven point for oil producers is much higher. Eventually they’d re-adjust.
Yellen isn’t looking for a rebound in oil prices, but rather stability.
Despite the ongoing weakness in inflation, Federal Open Market Committee members unanimously supported Yellen in the decision to raise rates.
Yellen also said the Fed does not want the economy to overshoot the employment and inflation objectives and then have to raise rates abruptly and potentially push the economy into recession. Rates have been near zero since December 2008 and the U.S. exited its recession after the financial crisis over six years ago.
Implications for Canada
The Fed rate hike reflects a strengthening U.S. economy, which bodes well for the Canadian economy and is “one that matters very much to our outlook,” said Bank of Canada governor Stephen Poloz at the Canadian central bank’s financial system review press conference on Dec. 15 in Ottawa.
The BoC expects Canadian economic growth to strengthen in 2016 after a challenging 2015. This depends on continued improvement in non-resource exports and exchange rate-sensitive exports, which are primarily destined for the U.S.
Regarding Canadian interest rates, Poloz said, “We could look at past experience and see some movement in our bond markets; our longer-term interest rates move in sympathy with whatever happens with the U.S. yield curve.”
The BoC, in its Jan. 20 monetary policy report, will have a comprehensive evaluation of the Canadian economy reflecting the new developments in the U.S.
Markets were pricing in roughly an 80 percent chance of a 0.25 percent Fed rate hike. They got what they wanted and behaved accordingly. Stock markets rallied about 1 percent after the announcement while bond yields showed little reaction. The loonie continued to trade around US$0.725.
The long process of normalizing monetary policy in the U.S. has finally begun.
Follow Rahul on Twitter @RV_ETBiz