Federal Reserve hikes rates again: More to come?

A perspective from E*TRADE Capital Management, LLC

12/19/18

This time around it wasn’t necessarily a given. Few doubted the Federal Reserve would increase interest rates earlier in the year, but as this week’s much-anticipated policy meeting approached, there was a bit less certainty. In fact, the CME FedWatch Tool pegged the probability of no rate hike at roughly 30% shortly before Wednesday’s announcement.1 In the end, however, the Fed pulled the trigger and raised the overnight fed funds rate by 25 basis points (0.25%) to a target range of 2.25–2.50%. It was the fourth such rate hike in 2018 and the ninth since 2015.

A balancing act between managing inflation and hindering growth

In deciding whether to raise interest rates, the Fed had to weigh the risks of inflation against disrupting a healthy US economy that has pushed unemployment rates to a 49-year low.2 The Fed’s preferred barometer of inflation—the core Personal Consumption Expenditure (PCE) Index—is running at just under 2%. That is near the Fed’s long-term target rate, which suggests the Fed believes both the economy and inflation are right on track.

Wednesday’s decision is part of a rate normalization process that has gradually lifted the fed funds rate from near 0% just a few years ago. The Fed has a statutory mandate to balance employment and price stability and needs a full quiver of arrows to do so. Only by raising rates will the Fed have the option to consider lowering them should the economy cool off in the future. Despite today’s 0.25% increase, however, interest rates are still low from a historical standpoint.

US fed funds target rate, 1988-present

Source: FactSet Research Systems


Will we see more rate hikes in 2019?

No one knows for sure what 2019 holds in store, but recently Federal Reserve Board Chairman Jerome Powell hinted that the Fed’s tightening campaign may be in its final stages. Last month, Powell noted that interest rates were just below estimates of neutral.3 A short-lived market rally ensued in hopes that all of the additional rate hikes previously telegraphed by the Fed wouldn’t come to pass.

For much of the past year, the Fed’s policy-making arm—the Federal Open Market Committee (FOMC)—has been hinting at two to three more 0.25% rate hikes in 2019. Whether that actually happens will largely hinge on the pace of economic growth and the aforementioned core PCE Index, which has trended lower of late.  

Core PCE Index

Source: FactSet Research Systems, Bureau of Economic Analysis


US economy still humming, but risks abound

While higher interest rates increase the cost of borrowing and are often frowned on by the markets, it’s important to keep in mind that the Federal Reserve raised rates because the economy is on a roll. Any deceleration in the pace of monetary easing would likely signal that the decade-long economic expansion is beginning to lose steam. For the time being this doesn’t appear to be the case, but risks are still present in the form of a weakening housing market, inconsistent job growth, and escalating market volatility.

Bottom line for investors

Regardless of how the markets react to the Fed’s belt tightening, investors should remain focused on their long-term financial goals. While certain strategies can perform well in a rising rate environment, investors diversified across a broad range of equity and fixed income assets should be well-positioned for continually changing economic and market conditions.

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1. CME Group, CME FedWatch Tool, December 14, 2018. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

2. “U.S. gains 155,000 jobs, unemployment stays at 3.7% in plain-vanilla November labor report,” MarketWatch, December 7, 2018, https://www.marketwatch.com/story/us-gains-155000-jobs-in-november-and-unemployment-rate-stays-at-37-2018-12-07

3. “Fed Chairman Says Interest Rates Are Just Below Estimates of Neutral,” Wall Street Journal, November 28, 2018. https://www.wsj.com/articles/fed-chairman-flags-rising-indebtedness-of-some-u-s-businesses-1543424400