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Fed Raises Rates: What Should the Markets Expect?

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RANDY FREDERICK: After waiting more than a full year since their last interest rate increase, the Federal Reserve Board finally decided to raise their fed funds target rate another quarter point. And while the move was largely expected, Liz Ann Sonders, Schwab’s chief investment strategist, joins me for the December 14 Schwab Market Snapshot to discuss the Fed’s commentary and what investors need to know going forward. Welcome back, Liz Ann.

LIZ ANN SONDERS: Thanks, Randy, and thanks, everybody, for tuning in.

RANDY: So, Liz Ann, the futures market has been forecasting this interest rate increase at like 100% probability for about the past four weeks. And now that it has happened, were there any details in the announcement or in the Fed’s press conference that surprised you?

LIZ ANN: Well, Randy, as you suggested, the headline—the fact that they raised rates by 25 basis points—was a surprise to nobody. You know, within the statement, the good news is, is that they did upgrade their assessment of the economy. They tend to focus with forecasts on GDP and the unemployment rate. Also, importantly, though, they talked a bit more about the risk of inflation pressures heating up here. And I think that’s why looking into 2017, they are now expecting to raise rates three times. So I think the general takeaway was that this was a bit more of a hawkish Fed. And for those that don’t understand the term, that just means the possibility that they might be a bit more aggressive than expectations were certainly back in September and even maybe more recently.

RANDY: Well, now, one thing that we usually get when the Fed does hold a press conference is an outlook on interest rates in the future, and sometimes that’s called the “dot plot.” So what changes did the Fed make to their dot plot for 2017? And do you think investors need to keep an eye on that in the coming months?

LIZ ANN: Yeah, in fact, I think that was probably the most focused-on aspect of both the meeting, as well as this statement that followed it. And the dots plot, as you mentioned, actually has a component that’s the Fed’s expectations for where interest rates are going to go over the next three years, but, importantly, it tends to be tracked against the market’s expectations by using the fed funds futures market. And what’s interesting is for the first time, you actually saw both lines, both sets of dots move higher. So the Fed upped its expectations for interest rates looking out to 2019 by about 25 basis points in 2017—more than where they were in September. Another 25 basis points more at 2018, and then about 40 basis points more in 2019. But the market also moved up, and I think, importantly, the gap narrowed between what the market expects and what the Fed expects. In fact, the market is now actually a touch higher than the Fed for 2017. Now, that could be good news, in the sense that it may mean with that convergence in the two lines that we’re less likely to see kind of a shocking surprise from the Fed because the market and the Fed are on more similar paths in terms of the interest rate outlook.

RANDY: Well, that’s interesting, because based on the Fed’s forecast way back in December of 2015, they were pretty optimistic. They were expecting to be at something like 138% right now. And I think we said that that was probably way too aggressive. So what is their outlook for 2017, and do we think they are still being a little bit too aggressive?

LIZ ANN: So you’re right, and it was clearly the case of the market, which had a much lower set of projections looking out for interest rates in 2016, the market was right in 2016. Now that the market has converged toward the Fed, not only do we think the Fed is likely to be more right this year. One important takeaway from the press conference that Janet Yellen had today was when asked about whether the members that published their forecasts on their rate trajectory had incorporated the possible fiscal stimulus coming from the incoming Trump administration—she noted that most had not. So, if anything, maybe not for 2017, but I think there is a risk that the Fed may have to be more aggressive in terms of interest rate increases if that stimulus leads to stronger economic growth, and, in particular, with that, stronger inflation.

RANDY: Yeah, so it seems like no matter what they say, it’s going to be a big wild card because of the new administration.

LIZ ANN: Exactly.

RANDY: Thank you so much, Liz Ann. Those are great insights. We’re out of time.

If you have any questions, please call and talk to a Schwab professional. You can read more from Liz Ann and get her commentary on the Insights section of Schwab.com. You can follow her on Twitter @LizAnnSonders, and you can follow me on Twitter @RandyAFrederick. We’ll be back again. Until next time, invest wisely. Own your tomorrow.

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