In a widely anticipated move, the Federal Reserve (Fed) raised short-term interest rates 25 basis points at the December 12-13 meeting of the Federal Open Market Committee (FOMC). The hike pushed the federal funds rate target to a range of 1.25 percent – 1.50 percent and marked the Fed’s third tightening move this year—its fifth rate increase since embarking on interest rate normalization in December 2015.
In addition, the balance sheet reduction strategy the Fed launched in October remains on track. As that strategy outlined, the net dollar amount of balance sheet cuts from maturing securities will increase in January. The Fed will allow $12 billion in Treasury securities (up from $6 billion) and $8 billion in mortgage-backed securities (up from $4 billion) to roll off monthly in the first quarter of 2018. Beginning in April, the net dollar amount will increase again for another three-month period.
Upbeat Economic, Jobs Data Prompted Tightening
In explaining its rate-hike decision, the Fed noted in a statement that “the labor market has continued to strengthen and … economic activity has been rising at a solid rate.” The central bank also cited moderate expansion in household spending and recent growth in business fixed investment as supportive of solid economic gains. In addition, “with gradual adjustments” to monetary policy, the Fed expects economic activity to expand at a moderate pace and labor market conditions to remain strong.
Growth Forecast Rises
Compared with its September projections, the Fed boosted its economic growth forecast for this year and next. Consistent with our outlook for modest economic growth, Fed officials now expect the U.S. economy to grow 2.5 percent in 2017 and 2018, up from their September projections of 2.4 percent and 2.1 percent, respectively. Against this backdrop, the Fed reaffirmed its plan for three rate hikes in 2018.
Inflation Outlook at Odds With Fed’s Rate-Hike Plans
The Fed’s outlook for three rate hikes in 2018 is largely contingent on core inflation reaching and remaining 2.0 percent, which we believe is an unlikely near-term outcome. The Fed’s favored inflation gauge—the core personal consumption expenditures index, or core PCE—was 1.4 percent (year over year) in October, unchanged from September. Given our outlook for modest economic growth and lackluster wage growth, we do not foresee any specific catalysts driving prices significantly higher. Therefore, barring any significant changes in the growth and/or inflation outlooks, we currently expect no more than two Fed rate hikes in 2018.
New Fed Chair Likely to Stay the Course
As the Fed considers its monetary policy strategy in 2018, it will do so under new leadership. Current Fed governor Jerome Powell, President Trump’s pick for Fed chairman, is set to succeed current Chair Janet Yellen in February 2018. The Fed’s path to balance sheet and interest rate normalization is unlikely to waver under Powell’s chairmanship.
Similar to Yellen, Powell has advocated for a slow, data-dependent tightening of monetary policy. However, unlike Yellen, Powell favors less federal regulation—a stance that puts him in the same camp as President Trump. We expect Powell, along with President Trump’s other appointments to the Fed’s Board of Governors, to maintain the central bank’s long-standing gradual path to normalization, particularly given the likelihood of continued modest growth and sluggish inflation.
Overall, we believe the Powell-led Fed will remain generally accommodative and in line with President Trump’s policies on deregulation. The Fed’s efforts to reduce the central bank’s balance sheet should continue to have minimal impact on the broad bond market, largely due to the Fed’s transparency regarding the balance sheet cuts, the gradual pace of the wind down, and steady investor demand for fixed-income securities. Overall, the yield curve should remain relatively flat, with the front end rising on Fed normalization, and the long end moving more modestly on subdued inflation and moderate growth.
Generally, as interest rates rise, bond values will decline. The opposite is true when interest rates decline.
The opinions expressed are those of Dave MacEwen and are no guarantee of the future performance of any American Century Investments portfolio.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.