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What to Expect from the Fed's Rate Hike

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

The Federal Reserve board announced an increase of the federal funds rate of 0.25%. This is the third increase this year and the eighth since this rate hike cycle started in December 2015. The new federal funds rate moves the to a target range of 2.00% to 2.25%.

While the interest rate increase was expected, the financial markets are paying close attention to the comments from the chairman Jerome Powell to position for upcoming rate hikes going forward. The statement shows that the most board members are planning another rate increase this year, likely coming in December. Looking further ahead to 2019, the average forecast from board members is currently for three additional rate increases.

Keep in mind that the Federal Reserve can only directly control short-term interest rates. Longer-term rates are controlled by many factors including future inflation expectations, supply/demand of bonds, international interest rates and the overall risk sentiment in financial markets. The 10-year US Treasury rate has moved sharply higher since early September 2017, going from 2.02% to current levels around 3.10%. A key factor in this move is higher inflation expectations coming from the tax reform bill in December and large federal spending bill that passed earlier this year. This fiscal stimulus will likely add hundreds of billions of dollars to the economy over the upcoming years.

In addition to rate hikes, the Federal Reserve also continues to decrease the size of their balance sheet that was built up during the three quantitative easing programs in the years following the financial crisis. After reaching a level of approximately $4.5 trillion dollars, this balance sheet reduction started in September 2017 with $10 billion of US Treasury bond and mortgage backed securities that were allowed to mature without reinvesting the proceeds. Starting next month, the Federal Reserve will allow $60 billion of bonds roll off each month without reinvestment. While still a small amount relative to the remaining size of the balance sheet, there will continue to be reduced demand for bonds that will need to be made up by other investors.

The Federal Reserve board continues to be data dependent and will adapt the current plan as they monitor economic data. The next meeting will be on November 7th and 8th with current expectations that they will leave the federal funds rate at current levels.

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