Red rate hike news

December Rate Hike

Analysis by Ryan Lange, CFA, CAIA Senior Investment Strategist

December 13, 2017

By: Ryan Lange

As widely anticipated, the Federal Reserve announced a 0.25% increase in the Federal Funds rate today with a 7-2 vote. This pushes the target range up to 1.25% - 1.50%. This is the third 0.25% rate hike this year following one in 2016 and one in 2015.

The economy continues to show signs of economic growth. As the labor market strengthens, with unemployment down to 4.1%, core inflation continues to remain below the Federal Reserve target of 2.0%. A puzzling issue for the Fed is stable wage growth in a tight labor market. If this wage growth starts to pick up, watch for inflation to also pick up and the Federal Reserve to pick up the pace of future interest rate increases.

Looking into 2018, the average forecast for board members at the Federal Reserve expect three additional rate hikes. This would push the Fed Funds rate up to a level of 2.00% - 2.25%. Investors in the fixed income market are being more cautious with expectations of only 1 or 2 more rate hikes. One key item to watch is what happens to the yield curve. As the short-term rates move higher from the higher Fed Funds rate, unless longer term rates also increase, we will see a flattening yield curve where short-term and long-term rates are at similar levels. As of today, the 10 year US Treasury has a yield-to-maturity of 2.35%. The risk of the flat yield curve is that it is a leading indicator of an upcoming recession.

In addition to the increases in the Fed Funds rate, keep in mind that the Federal Reserve is also reducing the size of their balance sheet by reducing the size of bond maturity reinvestments each month. This process started in October and will continue into next year. For the past few years, they maintained a balance sheet close to $4.5 trillion. Right now they are allowing $10 billion to roll off the balance sheet each month. This amount will increase to $20 billion per month in January, $30 billion in April, $40 billion in June, and $50 billion in September 2018. If not controlled, this could lead to higher intermediate term interest rates. The board members of the Federal Reserve will continue to monitor the health of the economy and make appropriate adjustments to the plan as necessary. This will allow them to use more than one tool to stimulate the economy again if the economy slows.

The meeting this week was the final one with Janet Yellen as the chairwoman. Jay Powell will take over as the chairman next year and is projected to keep the financial policy on the same path as Yellen.

Ryan Lange, CFA, CAIA
Senior Investment Strategist
Great Western Bank Wealth Management

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