In a Nutshell: â€œThatâ€™s one small step for the Fed, one giant move toward normal financial markets.â€
Rate Decision: Fed funds rate range increased to between 0.25% and 0.50%
Well, they finally did it. After hinting and backing off, The FOMC raised the fed funds target range by one-quarter percent. This is the first move of any type since December 16, 2008, when the 0% lower bound was hit, and the first increase since June 26, 2006, when the 25 basis point increase brought the rate to 5.25%. In between we had the housing bubble bursting, the financial system in near collapse and a recovery that is still scarred by the excesses of the last decade.
Very simply, it is good to get this finally out of the way. History will determine whether this was the right time to make a move, but it had to be made and in my mind, this was as good a time as any. Actually, I think if they had gone in June or September, that would have been fine as well, but I donâ€™t want to be critical â€“ at least not right now.
Most importantly, we can now focus on the next stage of the move back to normal bond and stock markets. There are lots of additional actions that must to be taken: We need a funds rate that reflects normal conditions, the Fedâ€™s balance sheet needs to be shrunk and assets need to be shed, and the marketsâ€™ obsession with Fed future actions, or lack thereof, must be reduced.
So, where do we go from here? There is little doubt that â€œthe dataâ€ will drive Fed decisions â€“ they just keep telling us that. So letâ€™s project out one year from now. The unemployment rate is likely to be at or even below 4.5% and labor shortages will be common, wages will probably be rising at a solid pace, the restraining impacts of declining energy costs should be behind us and businesses will be needing to make up for lost ground due to all the uncertainties they have faced. In addition, Europe will have another year of quantitative easing and China will be another year into its transition to a more balanced, consumer-driven economy. In other words, the economic environment is setting up for a very solid 2016 that should support moves at roughly every other meeting to begin with but maybe more frequently by the end of next year.
But reading the Fedâ€™s statement, while the members seem to be comfortable with current and future economic conditions, there appears to be some unease about the inflation prospects. The Committee mentioned that some surveys indicate that inflation expectations have â€œedged downâ€ and there was an added statement that inflation would be monitored closely. Since inflation is still an outlier, the pace of future hikes may be linked more to progress on reaching the Fedâ€™s 2% inflation target than on the strength of economic growth. The problem, of course, is that inflation tends to be a lagging indicator. As economists used to note, â€œIf the Fed waits until it sees the whites of inflationâ€™s eyes, it has waited too longâ€.Â Â It is not clear what the Fed will use as a leading indicator of inflation.
Looking longer-term, since the Fed has to get to a â€œneutralâ€ funds rate before inflation heats up, and that rate is assumed to be about 3.5%, the FOMC has a lot of work to do. Unless the economy slows, energy prices keep falling and the dollar keeps rising, it is doubtful it will take three years to get there.
Finally, unless we have a perfect economy and inflation stabilizes close to the Fedâ€™s 2% target, the FOMC will not stop at neutral. It hasnâ€™t in the past and there is little reason to believe it will now. So when you start thinking about the terminal rate, it is prudent to assume that it is above the 3.4% long-term rate the members indicated in their â€œdot chartâ€. Donâ€™t be surprised if we get to 4.00%. But for the next nine to twelve months, expect only gradual increases in rates.
(The next FOMC meeting is January 26-27, 2016.)