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Fed Raises Rates, Projects Faster Pace of Future Hikes

Key Points
  • The Federal Reserve raised its target range for the federal funds rate, as expected, on Wednesday. The range is now 1.75% to 2.0%.

  • Projections suggest two more rate hikes this year, signaling a faster pace of tightening than the March projections indicated.

  • Fed Chairman Jerome Powell indicated that there will be press conferences after every FOMC meeting, beginning next January.

  • Overall, the outcome of the meeting was largely in line with expectations, but it signaled that the Fed is focusing on tightening policy further in response to low unemployment.

As expected, the Federal Open Market Committee (FOMC) on Wednesday raised the target range for the federal funds rate¹ by 25 basis points, to 2% from 1.75%. This marks the second rate hike this year and the seventh since the tightening cycle began in December 2015.

Overall, the rate increase and accompanying communications underscored that Federal Reserve policymakers appear to be growing more confident that the economy is reaching full employment with inflation near its 2% target rate, so the central bank’s bias may be toward tightening sooner rather than later.

“Dot plot” suggests faster pace of rate hikes

The important shift by the Fed was seen in its new dot plot, which provides insight into the Fed’s thinking about the pace of rate hikes. The Fed is projecting that it will raise interest rates the same number of times, but more quickly. Based on the dot plot, the committee’s median estimates for the pace of rate hikes suggest that there could be a total of four rate hikes this year, up from three implied in the previous estimate. Additionally, the projections imply three rate hikes in 2019 and then one more hike in 2020. However, the long-run federal funds rate is still projected to be near 3%. This projection is viewed as the Fed’s estimate of the “neutral rate,” the rate that neither slows nor accelerates inflation.

The new dot plot implies two more rate increases this year

Source: Bloomberg. FOMC Dot Plot, (DOTS SPEC), the Implied Fed Funds Target Rate Curve and the Overnight Index Swap (OIS), as of 6/13/2018

Notes: The FOMC dots median reflects policymakers’ expectations for interest rates. The Fed Funds futures rate is what investors expect the federal funds rate to be in the future. The overnight index swap (OIS) is an interest rate swap involving the overnight rate being exchanged for a fixed interest rate. An overnight index swap uses an overnight rate index, such as the overnight federal funds rate, as the underlying rate for its floating leg, while the fixed leg would be set at an assumed rate.

Tweaks to other estimates were minor. There was a slight increase in the projection for gross domestic product (GDP) growth in 2018 to 2.8% from 2.7%, but no changes to the expected growth rate for the next few years or in the longer run. Similarly, the Fed expects the unemployment rate to fall to 3.5% over the next few years, compared with the current rate of 3.8%.

However, expectations for the pace of core inflation were lifted for this year, but not for the next few years. The inflation rate that the Fed focuses on—the core PCE²—is still estimated at 2.1% in 2019 and 2020. The implication is that the Fed hasn’t changed its long-term outlook for the economy or inflation. However, it does reflect the impact that tax cuts and spending increases are having on growth in the near term.

Economic projections of Federal Reserve board members and Federal Reserve Bank presidents 

Source: Federal Reserve Board, as of 06/13/2018.

Notes: For each period, the median is the middle projection when the projections are arranged from lowest to highest. When the number of projections is even, the median is the average of the two middle projections. The central tendency excludes the three highest and three lowest projections for each variable in each year. The range for a variable in a given year includes all participants' projections, from lowest to highest, for that variable in that year. Longer-run projections for core PCE inflation are not collected.

A few tweaks to communications

In the statement that accompanied the rate change, there were a few notable changes to the language. The Fed is no longer indicating that policy “will remain accommodative for quite some time.” It makes sense to remove that statement as the Fed moves toward tighter monetary policy and higher “real” interest rates—that is, rates adjusted for inflation. Powell indicated that balance sheet reduction would continue on schedule and that the primary tool for adjusting monetary policy is the federal funds rate.

Powell also announced that starting next January the Fed will hold press conferences after every meeting, rather than just at the quarterly meetings that include updated projections. He indicated that it doesn’t necessarily indicate that the Fed will be altering its policy more often. However, it is likely to increase uncertainty in the market around Fed policy meetings, which could mean higher volatility over the long run.

Takeaways for investors

In response to falling unemployment and inflation edging toward its 2% target, the Fed is likely to continue to raise short-term interest rates over the next few years. However, the committee’s long-term views still suggest that growth and inflation will remain at moderate levels.

As monetary policy tightens, we expect the yield curve to flatten, with short-term rates rising more than long-term rates and the dollar to continue firming up. Most importantly, monetary policy is moving from an “easy” stance to a “tighter” stance. The shift will likely mean higher volatility in markets.

 

¹ The federal funds rate is the interest rate at which depository institutions, such as banks and credit unions, lend reserves overnight to other depository institutions.

² The “core” PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.

What You Can Do Next

  • Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982, visit a branch or find a consultant.
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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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