A sneak preview: Interest rates are expected to rise next month

A perspective from E*TRADE Securities2

08/30/18

The Federal Reserve is scheduled to convene in Washington, DC, September 25–26, to which we add, with a theatrical flourish: “with a press conference included.”

Big deal, you say? Well, a press conference is a big deal in Fed land. It means the Federal Reserve’s policymaking arm—the Federal Open Markets Committee (FOMC)—will make a decision on interest rates. And, by all indications, the announcement will be that the Fed is raising interest rates for the third time this year and for the eighth time since 2015. So, in these last few days of summer, we’re revisiting monetary policy to preview what could be an eventful remainder of the year.

Despite rate hikes, interest rates still at historic lows

At its June meeting, the Fed raised the target federal funds rate—the overnight rate at which banks lend to each other—to a range of 1.75%–2.00%. That’s a lot higher than the near-0% rates in the years following the 2008–2009 financial crisis, but it’s still low by historical standards.

As you can see in the chart below, the target fed funds rate was north of 5% as recently as 2007 and hovered at 6.5% just before the collapse of the tech bubble in 2000.  

US federal funds target rate

Still, the Fed is clearly in tightening mode, and, based on its own projections, it won’t be done raising rates for a while. In fact, in June, the Fed surprised some observers by telegraphing a total of four rate hikes in 2018—one more than most market savants were expecting. That means we’ll likely see another 0.25% rate increase in mid-December, when the FOMC meets … with a press conference included.

The strong economy carries with it inflation concerns

As for its upcoming meeting, the Fed provided a preview of sorts when it released the minutes of the FOMC’s August meeting last week. Among the salient points:

•  Financial conditions are supportive of economic expansion

•  Gross domestic product (GDP) is likely to slow in the second half of 2018 but will likely “exceed that of potential output”

•  GDP growth is supported by a strong labor market, stimulative fiscal policy, and high levels of household and business confidence

•  Household spending and business investment have grown strongly1

The common denominator is that the economy is hot, which means conditions are ripe for more monetary tightening.

It’s about inflation—not the stock market

The Fed’s likely course of action is underscored by another key point from the August minutes: “Gradual increases in the federal funds rate will be consistent with … inflation near the Committee’s symmetric 2 percent objective over the medium term.”1

There’s the magic word: inflation. Keep in mind that one of the Fed’s primary goals is to achieve maximum employment along with price stability. As long as inflation is near the Fed’s 2% target, the FOMC is likely to continue raising rates in order to prevent inflation from inching higher.  

That is not good news to everyone. Recently, President Trump expressed disappointment that Federal Reserve Chairman Jerome Powell has not been the “easy money” chieftain the president expected when Powell was appointed in January.2 Instead, Powell has systematically moved toward rate normalization.

But, again, the Fed’s goal is not to support the financial markets or to artificially gin the economy. Rather, the central bank’s mandate is to strike a balance between maximum employment and inflation—in this case, with a target rate of 2%.

Whither the rate hikes?

Just how many more rate hikes can we expect in the coming years? While it’s impossible to know for sure, the Fed’s “dot plot,” which maps out the midpoint of each FOMC voting member’s rate expectations, holds some clues. Based on the current dot plot shown below—and assuming the fed funds rate finishes the year in the 2.25%–2.50% range—we could see three additional 0.25% rate hikes in 2019.

Federal Reserve dot plot

Source: Board of Governors of the Federal Reserve System

The FOMC’s voting members could change their positions as conditions warrant, of course, but for now the dot plot is a reasonable indicator of where the Fed believes it is headed. Meantime, the CME FedWatch Tool, which reflects market expectations, is expecting the fed funds rate to land closer to 2.75% next year.3

Fasten your seat belts

While particular strategies can perform well in a rising rate environment, investors with a broad range of equity and fixed income holdings should be well-positioned, regardless of what the Fed decides.

In the meantime, don’t be surprised to see some volatility around the Fed meeting in September, even though the market has largely baked in a 0.25% rate increase. As we saw in June, the real news isn’t necessarily what the Fed does, but what it projects it will do in the future.

In a few more weeks, we should be better able to connect the dots.

1. Minutes of the Federal Open Market Committee, July 31-August 1, 2018, https://www.federalreserve.gov/monetarypolicy/fomcminutes20180801.htm

2. The Hill, “Trump ‘not thrilled’ at Fed chief’s interest rate hikes,” August 20, 2018, http://thehill.com/policy/finance/402722-trump-bashes-fed-chief-powell-in-interview-with-reuters

3. CME FedWatch Tool, August 28, 2018, https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html