U.S. Fed lifts benchmark interest rate for first time in 2017

A perspective from E*TRADE Capital Management, LLC

03/15/17

The Fed makes a move for a second time in three months

At its policy meeting on March 15, 2017, the Federal Open Market Committee (FOMC) increased the benchmark interest rate, known as the federal funds rate, by 0.25%, or 25 basis points. The rate is now 0.75–1.00%, or 75–100 basis points (a basis point is one one-hundredth of a percent).

The Federal Reserve (the Fed) cited healthy economic growth, a steadily expanding labor market with wage growth, and a continued pickup in inflation as reasons for the increase. The rationale is in line with comments from Fed committee members prior to the meeting.

This move, which follows the 0.25% increase in December 2016, suggests the Fed could be on its way to normalizing interest rates after keeping them low due to the financial crisis and the slow rebound thereafter. The Fed’s recent actions speak to the continued improving health of the economy overall, while maintaining modest core inflation. 

What could this mean for markets?

The road to this increase has been winding indeed. Market participants initially appeared undecided about whether the Fed would move. But expectations for an increase shifted dramatically following the release of the Fed’s January 31–February 1 meeting minutes and gathered momentum on comments from Fed officials focusing on labor market expansion, wage growth, and target core inflation as key to their decision making. It may take some time for investors to acclimate to the news, which some market observers believe could result in higher volatility. 

  • An unclear fate for U.S. equities. The debate on what will happen in these markets will likely rage for days or weeks to come. While the federal funds rate is now as high as it has been since late 2008, it is still low by historical standards. Continued accommodative policy from the Fed could help sustain the market’s momentum.  History is also on the side of U.S. stocks: The bull market that began in early 2009 remains intact, and secular bull markets often last for more than a decade. On the other side of the coin, market participants will need to assess whether rate hikes have been fully priced into the market. Upward moves could give investors pause and pressure U.S. equities as they assess the impact of higher rates on corporate profitability.
S&P 500 closing values since December 2008

Source: Standard & Poor's

  • A similar story for international equities. The U.S. dollar has appreciated significantly against most currencies since 2014, which is a trend that some think will continue as foreign investors seek higher interest rates in the U.S. and the continued comfort of a safe haven currency. This could lead to an increase in exports from foreign countries, helping to pave the way to higher economic growth abroad. 
  • Fixed income could be soft. Interest rates are due to rise, particularly short-term interest rates two years and less, which are closely tied to the fed funds rate. However, some observers predict that any move substantially higher from here may be tempered by surging demand from yield-starved investors. For example, while rates are still low in the U.S., they are even lower in Japan and numerous countries in Europe, including France, Germany, and Switzerland.
2y Treasury yields since December 2015

Source: U.S. Department of the Treasury

Are more rate increases on the horizon?

Many feel that the Fed is well-positioned to deliver the three interest rate increases it has implied for 2017, barring a major development. While in 2016 the Fed appeared to be seeking reasons to hold off from raising rates, it may be this year the Fed is looking for reasons to act.

Factors that could influence the Fed’s decision include new economic data (particularly output growth, labor market expansion, and core inflation), future fiscal, tax, and trade policy, not to mention the market’s reaction to today’s news.

The bottom line for investors

All investors can use market events, like Fed decisions, as opportunities to review and rebalance their portfolios as appropriate, keeping them aligned with their risk tolerance. We believe investors with broadly diversified portfolios of domestic and global equities, fixed income securities across the credit and maturity spectrum, and cash should be well-positioned for all types of market developments over the long term.

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 contact your E*TRADE Financial Consultant if you have one, or call us at 1-800-ETRADE-1 (1-800-387-2331). We’re always ready to help.