Fed hikes rates, signals two more for 2018

Myles Udland
Markets Reporter

The Federal Reserve raised interest rates on Wednesday for the seventh time since the financial crisis.

In its monetary policy statement released Wednesday, the central bank increased the target range for its benchmark interest rate by 0.25% to a range of 1.75%-2%, the highest since September 2008. All eight voting members of the FOMC voted in favor of Wednesday’s decision.

In raising its benchmark interest rate, the Fed cited an economy that is growing at a “solid” rate, an upgrade from its characterization in May of an economy growing at a “moderate” rate.

The Fed added that job gains that have been “strong” in recent months and that, “Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly.” In May, the Fed noted that household spending had “moderated” from its strong pace in the final quarter of 2017.

The most notable change to the Fed’s statement is the elimination of language suggesting that its policy would “for some time” remain accommodative.

In May, the Fed said, “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.” This language had been a feature of Fed statements for years. The clause was eliminated from the June statement. Ahead of Wednesday’s statement, some economists had speculated this language would be dropped.

This tweak suggests Fed officials see monetary policy as nearing its neutral rate setting, or the interest rate at which the economy would experience full employment and price stability, which the Fed has defined as 2% inflation.

Summary of economic projections

The Fed’s latest release also included an updated summary of economic projections, which are aggregated economic, labor market, and interest rate forecasts from Fed officials. In this release, the Fed raised its outlook for growth and inflation this year while lowering its expectations for the unemployment rate.

These projections also include the Fed’s “dot plot,” which illustrates expected future interest rates, and now shows most Fed officials see two additional rate hikes coming in 2018, bringing the year’s total to four.

Federal Reserve

In March, Fed officials were split on whether two or three additional rate hikes would be warranted over the balance of the year.

On the labor market side, Fed officials lowered their median expectation for the unemployment rate this year to 3.6% from 3.8% in March,. The Fed also lowered its expectations for the unemployment rate in 2019 and 2020 to 3.5% from 3.6%. Over the longer run, Fed officials still expect the unemployment rate to be 4.5%.

Since the Fed raised interest rates at its March meeting, the unemployment rate has dropped a further 0.3% to a 48-year low of 3.755% while the economy has added 537,000 jobs over that period.

After increasing their forecasts for GDP growth notably in March, Fed officials on Wednesday again increased expectations for economic growth this year, now forecasting the economy will grow 2.8% in 2018. In March, the Fed had forecasted growth of 2.7% in 2018; a year ago, the Fed expected the economy would grow 2.1% this year.

The Fed also reiterated its median expectation that the U.S. economy will grow 2.4% in 2019, 2% in 2020, and 1.8% over the long run.

Inflation also got a 0.1% boost in Wednesday’s projections, with Fed officials now expecting that core PCE inflation – which is the Fed’s preferred inflation reading and strips out the more volatile costs of food and gas – will be around 2% this year. The Fed maintained its view that core PCE inflation would be 2.1% in each of the next two years.

Federal Reserve

Wednesday’s decision also included a technical tweak to the Fed’s interest rate policy, as the interest paid on excess reserves (IOER) will now be 1.95%, or 5 basis points below the ceiling of the Fed’s target range of 1.75%-2%. IOER had formerly been set at the top end of the Fed’s targeted Fed Funds range.

In making this change, the Fed said it is, “intended to foster trading in the federal funds market at rates well within the FOMC’s target range.” In recent months, the effective Fed Funds rate had been around 1.7%, leaving only 5 basis points between the prevailing Fed Funds rate and the ceiling of the Fed’s target range.

Wednesday’s tweak in the IOER rate should bring the effective Fed Funds rate to around 1.9% if recent trends in that market prevail, doubling the cushion between the effective rate and the ceiling of the Fed’s targeted range.

The Fed on Wednesday also said it will increase the monthly caps of its balance sheet shrinkage by $10 billion per month beginning in July, bringing the total monthly reduction of its balance sheet to $40 billion from $30 billion as of June.

Myles Udland is a writer at Yahoo Finance. Follow him on Twitter @MylesUdland