Confident Fed Sets Stage for December Rate Increase
September 21, 2017 by admin
Filed under Choosing Lingerie
The Fed, which stopped its buying spree in 2014, is now preparing to pare back its holdings by about $10 billion per month initially. That is likely to raise borrowing costs for consumers and businesses, but only very slowly. Indeed, since the Fed ended its bond-buying, countervailing factors have actually reduced some borrowing costs, like the average interest rate on 30-year mortgages.
Investors are watching warily, but so far there is little sign that the Fed’s retreat is tightening financial conditions. Stock prices fell modestly after the Fed’s 2 p.m. policy announcement, but bounced back by the end of the trading day. The SP 500 index rose 1.59 points, closing at 2,508.24.
The yield on the benchmark 10-year Treasury also rose 0.02 percentage points, closing at 2.27 percent.
“The Fed did an extremely good job of preparing us for commencing the balance sheet rundown,” said Peter Hooper, chief economist at Deutsche Bank. “That’s happening with a whimper, but handled differently, it could have been a big event.”
The Fed, which has raised its benchmark interest rate twice this year, left that rate unchanged Wednesday, but indicated that it plans a third rate increase later this year as economic conditions continue to strengthen. The Fed said it expects the labor market to continue strengthening and the economy to expand at a moderate pace.
Twelve of the 16 officials on the Federal Open Market Committee predicted another rate increase this year, the same number as in the Fed’s last round of forecasts in June.
In its post-meeting statement, the Fed pointed to the strength of job growth and increases in household and business spending. The official optimism went only so far, however. Growth remains weak by historical standards, and the Fed indicated it sees no evidence of acceleration. Fed officials once again reduced their expectations for rate increases in coming years. The median prediction Wednesday was that the benchmark rate will stabilize at 2.8 percent, down from a median estimate of 3 percent in June.
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The Fed’s benchmark rate now sits in a range between 1 percent and 1.25 percent, a level most Fed officials regard as providing modest encouragement for borrowing.
Expectations of a third rate increase this year strengthened after the Fed’s announcement, rising from a 57 percent chance to a 71 percent chance, according to CME Group.
The Fed’s next meeting is scheduled for Oct. 31 and Nov. 1, but the Fed is unlikely to raise rates any sooner than its final meeting of the year, in mid-December.
Some economic indicators suggest that higher rates are warranted: The unemployment rate, at 4.4 percent in August, is below the level most officials regard as sustainable. Moreover, Fed officials predicted that the rate would fall to 4.1 percent next year.
But other economic measures paint a contrasting picture. Job growth remains strong, suggesting that the work force is still expanding; wage growth is modest, suggesting employers are still able to find workers with relative ease; and inflation weakened in recent months, puzzling Fed officials and economists who had predicted that prices would begin to rise more quickly as labor market conditions tightened.
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The Fed’s preferred measure of price inflation increased by just 1.4 percent during the 12 months ending in July, the most recent available data. The Fed is likely to undershoot its target of 2 percent annual inflation for the sixth consecutive year. That has caused consternation among some economists and Fed officials, who are wary of raising rates given the Fed’s inability so far to achieve its inflation objectives.
“I can’t say this year that I can easily point to a sufficient set of factors” to explain low inflation, Ms. Yellen said Wednesday. She added, however, that low inflation this year did not imply low inflation next year. “What we need to do is figure out whether the factors that have lowered inflation are going to prove persistent,” she said.
Ms. Yellen said that weak inflation readings earlier this year “reflect developments that are largely unrelated to broader economic conditions.” Similarly, she said that the Fed expected the impact of hurricanes on gas prices to increase inflation temporarily. So far, the Fed’s assessment of underlying conditions remains unchanged: Ms. Yellen and her colleagues expect inflation to stabilize at its target of 2 percent a year.
The Fed wants to use its benchmark rate to manage economic conditions while gradually draining its investment portfolio in the background. When Ms. Yellen described the Fed’s plans in June, she expressed hope that the process would be like “watching paint dry.”
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The Fed holds about $4.2 trillion in Treasury securities and mortgage bonds, which it accumulated to put downward pressure on interest rates. It must regularly replenish its holdings as bonds mature. Beginning in October, it plans to withhold $10 billion a month from the reinvestment process — in effect causing that much money to disappear.
It will then increase the pace by $10 billion each quarter until reaching a monthly rate of $50 billion, and then maintain that pace until it reaches an unspecified finishing line.
Ms. Yellen emphasized that the Fed did not plan to adjust that schedule, although she added, “unless we think that the threat to the economy is sufficiently great.”
The retreat will put modest upward pressure on borrowing costs, but businesses and consumers are unlikely to see much difference in the near term. “You will see a gradual tightening of financial conditions that will come from the Fed shrinking its balance sheet,” said Lewis Alexander, chief United States economist at Nomura Securities.
Still, questions remain, both about the market’s reaction and about the goal. Before the crisis, the Fed held less than $900 billion in assets, and most analysts expect the Fed to maintain a significantly larger balance sheet going forward — both because the financial system has grown and because the Fed has expanded its role in maintaining the system.
The Fed’s slow pace also means it will take years to rebuild its ability to respond to crises. It does not expect its benchmark rate to reach 2.8 percent for three years, and it expects to take even longer to reduce its balance sheet.
“If we get a severe adverse shock in the next couple of years and interest rates are still pretty low and the balance sheet is still pretty big, what in the world are we going to do?” asked Andrew Levin, a Dartmouth College professor of economics.
Ms. Yellen paused when she was asked that question on Wednesday.
“We have a certain amount of room now,” she finally said.
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She noted that the Fed could buy more bonds. It could also engage in “forward guidance,” or promising keep rates at a low level for a specified period.
The Fed also noted the impact of three recent hurricanes, including one that was striking Puerto Rico on Wednesday, but said the resulting economic disruptions were likely to be temporary.
“Hurricanes Harvey, Irma and Maria have devastated many communities, inflicting severe hardship,” the Fed said. “Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.”
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