A perspective from E*TRADE Capital Management, LLC
A surprise this was not—and the market knew it. The Federal Open Market Committee (FOMC) increased the federal funds rate, by 0.25% to 1.25–1.50%, or 125–150 basis points (1 bp = one one-hundredth of a percent). After 25-bp increases in March and June, this increase completes the Fed’s unofficial plan to tighten policy three times in 2017.
But that doesn’t mean the decision was straightforward. Fed minutes from the Oct. 31–Nov. 1 meeting indicate that inflation still has some Fed officials scratching their heads, because it remains below the Fed’s preferred 2% rate. As a result, some officials suggested a wait-and-see approach before further hikes. However, the majority were clear in their belief that continuing to normalize monetary policy was the best track.
As Fed Chair Janet Yellen said in late November, the FOMC has continued to gradually reduce policy accommodation with “ongoing strengthening in labor market conditions and an outlook for inflation to return to 2 percent over the next couple of years.”1 She added: “We continue to expect that gradual increases in the federal funds rate will be appropriate to sustain a healthy labor market and stabilize inflation.”
What could this mean for the market?
The Fed didn’t play coy. Officials seemed to go out of their way to telegraph a hike. On Wednesday morning, the CME FedWatch Tool, which calculates unconditional probabilities of FOMC meeting outcomes, pegged the chances of a 0.25% hike at 87.6%.
As a result, many market observers predict that equities will take the news in stride. Some have noted that these days the stock market is likely more interested in how corporate tax cuts take shape in the final tax reform bill.
Fixed income investors likely priced in the move, too. But they’re expected to keep eyes trained on the Treasury yield curve. Its flattening has accelerated: The spread between 2- and 10-year bonds, a common measure of the yield curve’s shape, has narrowed considerably, even with better economic growth and tighter monetary policy. In fact, it recently hit a post-recession low. Some say that could mean the bond market is not as convinced as others about the potency of the US growth story. It could also reflect what market participants believe the Fed has in store for next year—i.e., more tightening.
Source: The US Department of the Treasury
Is another rate increase on the horizon?
The Fed is set to be busy in 2018, a year that will include breaking in a new chairman. Officials have suggested multiple hikes, the first of which would likely be announced at the next FOMC meeting with a press conference (Mar. 20–21). But those increases are hardly set in stone.
Factors that could influence the Fed’s decision include new economic data—particularly output growth, labor market expansion, and, of course, core inflation. Tax reform could throw a monkey wrench into the Fed’s gradual hiking pace for growth and inflation.
That question will likely fall to Jerome Powell, the nominee to be the next Fed chair. Continuity seems to be the word market observers use to describe what they expect from Powell. In his Senate confirmation hearing, he backed Yellen’s approach to rates, noting that “patience has served us well.”2 He did add that while the Fed aims to “make the path of policy as predictable as possible,” it also needs to “retain the flexibility to adjust our policies” relative to future developments.
Source: The Federal Reserve
The bottom line for investors
The Fed’s third rate increase of the year is another step back to a neutral monetary policy, where it neither encourages nor stifles economic growth. Most recently, the Fed has considered “neutral” to be a 2.75% fed funds rate, so it has a ways to go.
And though conditions may not be perfectly aligned for an increase, the move speaks to what Powell mentioned in his Senate testimony: The Fed wants to rebuild its policy tool kit and create some flexibility for down the road.
For investors, Fed decisions can serve as checkpoints. They can be opportunities to review and rebalance portfolios to help keep them aligned with goals and risk tolerance. We continue to believe that investors with well-diversified portfolios of domestic and global equities, fixed income securities across the credit and maturity spectrum, and cash can be well-positioned over the long term for all types of market scenarios.
At E*TRADE, we’re committed to helping you make sense of the markets. If you have questions or would like to talk about your portfolio, please don’t hesitate to visit us at etrade.com to chat with us online, send us an email, or call us if you like at 1-800-ETRADE-1 (1-800-387-2331). We’re always ready to help.
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1. Yellen, Janet L. “The Current Economic Outlook and Monetary Policy,” 29 Nov. 2017. https://www.federalreserve.gov/newsevents/testimony/yellen20171129a.htm
2. Appelbaum, Binyamin. “Jerome Powell, the Fed Chair Nominee, Sees Continuity if Confirmed,” The New York Times, 28 Nov. 2017. https://www.nytimes.com/2017/11/28/us/politics/jerome-powell-federal-reserve-nominee-testimony.html