The Fed raised interest rates today – 14th December 2016 – by a quarter of a percentage point (25bps) to the 0.50%-0.75% range.
Janet Yellen has stated that this hike is a vote of confidence in the U.S. economy and labour market. The markets have priced the move in since the positive equity response to the Trump victory in November, and many analysts have been calling for a hike since September.
Why have they hiked?
It’s all to do with inflation. The Fed’s number one priority is to hit its 2% target. At the moment inflation is teetering around 1.5% (core PCE), but the job market is tightening. 150K+ jobs a month have been added on average this year and the U.S. has a healthy 5% unemployment level.
This labour market tightening leads to an upward pressure on wages, which in turn will cause firms to increase the prices of their goods to maintain profit levels.
Alongside the labour market, the US economy is also strong. GDP is growing at +2.9% in Q3, and Trump’s promise of $1tn in infrastructure spending is likely to boost economic growth further. In her post-event speech Yellen mentioned how a number of members of the FOMC factored in Trump’s anticipated changes to fiscal expenditure when deciding to raise rates.
If you are a non-economist you may wonder why the Fed doesn’t wait until inflation is at 2% before hiking. The reason they hike in advance of inflation is that monetary policy has a time lag – on average it takes over a year for the effects of a hike/cut to filter through the economy. This time lag results from rates affecting different parts of the economy and working through different mechanisms. For example the Fed rate rising 0.25% will result in mortgage rates rising by a small amount also (not necessarily 0.25%), however Banks may wait a few months before doing this and it may take a number of years before locked-in fixed rates are changed.
Due to this time lag the Fed are preparing the economy and changing rates now before inflation gets out of hand. In contrast the Fed was forced to raise rates rapidly in 2007 in response to inflation, arguably because they kept rates too low for too long; noted as a cause of the global financial crisis. In fact history shows the same happened in the build-up to the great depression.
What happens next?
- We should expect 2 or 3 rate hikes next year, providing the U.S. economy remains on track. Possibly more if Trump’s infrastructure spending policy ends up larger than expected.
- Inflation is likely to pick up – forecasts are at 1.9% from Fed.
- Equity markets should respond positively from this hike. Financials will strengthen over higher interest rates, whilst the stock market will see this as a hike ‘for the right reasons’ – a strong labour market and economic growth.