The Federal Reserve raised the target range for its benchmark interest rate at its March meeting, boosting the range by a quarter percentage point to 0.75% to 1.0%. The increase in the federal funds rate—the rate banks charge each other for overnight loans—was widely expected by the markets thanks to clear hints from Fed officials in the run-up to the meeting.
The Fed’s updated projections for the pace of hikes this year and next were unchanged. The decision to raise the target rate range drew just one dissenting vote: Minneapolis Fed President Neel Kashkari would have preferred to hold the target range steady.
The statement issued by the Federal Open Market Committee (FOMC), the Fed’s monetary policymaking arm, indicated a more upbeat outlook for the economy, consistent with statements from various Fed officials over the past few weeks. The statement reiterated that the “labor market has continued to strengthen” and that “economic activity has continued to expand at a moderate pace.”
The statement acknowledged that inflation has increased in recent quarters and was moving close to the Fed’s 2% objective, but it pointed out that core inflation measures—those that exclude volatile food and energy prices—continued to run below 2%. The statement also said inflation will likely “stabilize” around 2%, meaning the recent rise of some inflation measures above the 2% objective may be temporary.
The Fed’s Summary of Economic Projections suggested policymakers continue to project a total of three rate hikes in 2017—unchanged from the previous projections—with a target range of 1.25% to 1.5% by year end. That would mean two more quarter-percentage-point hikes this year.
Although the median target-range projection was unchanged, the number of Fed officials projecting a 2017 year-end range of 1.25% to 1.5% rose to 14, up from eleven Fed officials at the December meeting. The only median projection that changed was for year-end 2019, which moved up to a target rate of 3.0% from 2.88%, a very modest shift.
There were only minor changes to the economic projections. The core personal consumption expenditures (PCE) inflation projection for 2017 rose slightly to 1.9%, but was unchanged for the following years. Projections for the unemployment rate were relatively unchanged—the actual rate has hovered in the 4.6% to 4.8% for the past five months—but the “longer-run” projection dropped by 0.1% to 4.7%. Median projections for gross domestic product (GDP) changed only modestly, with the 2018 projection rising slightly to 2.1% from 2.0%.
Treasury yields dropped sharply immediately following the meeting, likely because the projected pace of hikes this year and next was unchanged. But keep in mind that Treasury yields had already risen significantly over the past few weeks in anticipation of the hike. Two-year Treasury yields had risen to their highest level since 2009, while five-year Treasuries were at their highest level since 2011. Even with the post-meeting decline, short- and intermediate-term Treasury yields remain at their highest levels in years.
The statement didn’t include any updates to the Fed’s plan to reduce the size of its balance sheet, keeping in place language that the central bank will continue to reinvest maturing securities. At the press conference after the Fed meeting, Fed Chair Janet Yellen didn’t provide any updates on the central bank’s plans for normalizing its balance sheet. The size of the Fed’s holdings of Treasuries and mortgage-backed securities can have a direct impact on yields of long-term bonds.
What investors can do now
The Fed has clearly communicated that the pace of rate hikes will continue to be gradual—but the pace in 2017 is likely to be faster than over the past two years, when the Fed hiked rates just once in 2015 and 2016.
We don’t think the prospect of rising short-term rates should send bond investors to the exits, however. Remember: The Fed’s influence is greatest on rates at the short end of the yield curve—as you go out further in maturity, the Fed’s influence wanes. That’s why bond yields don’t all rise in lockstep following a Fed rate hike. Longer-term bond yields are affected most strongly by expectations for growth and inflation, along with global supply/demand dynamics. Over time, rising inflation expectations tend to push long-term prices down and yields higher—until rate hikes begin to slow economic growth and reduce inflation expectations.
And even in a rising-rate environment, fixed income investments can provide important benefits, including income, diversification from stocks, lower volatility and the predictability of an income stream. Over the long run, bond holdings can allow you to take risk in other parts of your portfolio, by holding up when stock prices fall. Higher rates can also lead to opportunities for investors looking for higher yields.
Rather than abandoning fixed income holdings, we think investors should consider adjusting their allocations based on their investment objectives. For instance, you may want to shorten the average duration of your bond holdings, because shorter-term bonds tend to be less sensitive to higher interest rates than those with longer maturities. We suggest keeping the average duration of your fixed income portfolio in the short- to intermediate-term range—for instance, three years to five years. And if you’re thinking of retreating to the sidelines until the current rate-hike cycle is over, keep in mind that in past cycles, bonds yields tended to peak (and prices reach their lowest point) before the Fed was finished hiking rates—just another reminder that it’s difficult to time the market.