Autumn rate watching begins: Federal Reserve raises interest rates for third time in 2018

A perspective from E*TRADE Capital Management, LLC

09/26/18

Shrugging off trade tensions and a softening housing market, the Federal Reserve on Wednesday raised the federal funds rate by 25 basis points (0.25%) to a target range of 2.00–2.25%—the third such rate hike in 2018. The Fed has now lifted short-term interest rates eight times since 2015 and has signaled one more rate increase in 2018.

Despite rate hikes, interest rates still at historic lows

The latest rate increase was widely anticipated by market participants and reflects the continued march toward a normalized rate environment that began in 2015 when the fed funds benchmark rose from the 0% floor where it had hovered since the financial crisis.

Although the federal funds target rate—the overnight rate at which banks lend to each other—is now at its highest level in seven years, it is still low by historical standards. As depicted in the chart below, the fed funds target rate was above 5% as recently as 2007 and approached 10% in the late 1980s.

US fed funds target rate, 1988-present

Sources: FactSet Research Systems

Potential for additional rate hike in 2018

That interest rates are still historically low is important to bear in mind, as it means there is still ample runway for the Fed to raise the benchmark rate to what is considered a more neutral level—just shy of 3%, according to the Fed’s median long-range estimate.1 When rates are neutral, the Fed has more policy options at its disposal to tackle a wide range of economic conditions.

The market believes this latest rate increase will not be the last of the year. Since its June meeting, the Federal Open Markets Committee (FOMC)—the Fed’s policymaking arm—has consistently telegraphed a total of four rate hikes in 2018, which means we will likely see another 0.25% rate increase in mid-December at the FOMC’s next and final press conference of the year. Fed fund futures, which measure traders’ expectations for future rate increases, indicate a greater than 70% probability for a rate hike in December.2

And while market observers consider 2019 more of a question mark, as it stands today, the Fed’s “dot plot,” which maps out the midpoint of each FOMC voting member’s rate expectations, hints at three additional 0.25% rate hikes in 2019.3

Federal Rerve's "dot plot"

Source: Board of Governors of the Federal Reserve System

Strong US economy raises inflationary concerns

The FOMC’s August meeting notes highlighted a number of economic trends that support higher rates:

• Economic fundamentals are strong and continue to drive growth, despite indications of an expansion that may be long in the tooth.

• Gross domestic product (GDP) is likely to slow in the second half of 2018 but will likely “exceed that of potential output,” meaning that the economy is still chugging along nicely.

• The US currently enjoys a strong labor market and high levels of household and business confidence.

• Household spending and business investment have grown strongly.4

All of these points augur for tighter monetary policy that could head off inflation, which lies at the heart of the Federal Reserve’s monetary policy.

Inflation is right at the Fed’s target rate

Among the primary goals of the Federal Reserve is to help the US economy achieve maximum employment, coupled with price stability. Although many investors are familiar with the Consumer Price Index, the Federal Reserve’s preferred barometer for inflation is the core Personal Consumption Expenditure (PCE) Index, which excludes the volatile components of food and energy. In its most recent reading, the PCE Index rose 2% from the previous year, which matches the Fed’s long-term target inflation rate.5 Translation: inflation is right where the Fed wants it to be.

Personal Comsumption Expenditure Index (core) excluding food and energy

Sources: US Bureau of Economic Analysis, FactSet Research Systems

Monetary policy is set, but headline risks remain

Although higher rates have been anticipated for some time, the markets can react in any number of ways to Fed policy moves. In addition, an economic cold war of sorts between the US and several major trading partners, coupled with November’s mid-term elections, provide an air of uncertainty to the coming months.

Regardless of how the markets react, investors should stay focused on their long-term financial goals. While certain strategies can perform well in a rising rate environment, investors with a broad range of equity and fixed income holdings should be well-positioned for a variety of market conditions.


 

1. Board of Governors of the Federal Reserve System, “FOMC Projections materials, accessible version,” June 13, 2018. https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20180613.htm

2. CME Group, CME FedWatch Tool, September 20, 2018. https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

3. Board of Governors of the Federal Reserve System, June 2018. https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180613.pdf

4. Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee,” July 31–August 1, 2018. https://www.federalreserve.gov/monetarypolicy/fomcminutes20180801.htm