As expected, the Federal Reserve raised the federal funds rate by another quarter of a percentage point at its March meeting, bringing the target range for the benchmark rate to 1.5% to 1.75%. It was the sixth increase of the current hiking cycle.
The Fed also stuck with its forecast of three hikes for this year, meaning it expects two more in the months to come. At the same time, however, the central bank also raised its forecast for the number of rate hikes likely over the coming few years, with the median estimates in its “dots plot” for the fed funds rate at the end of 2019 rising to 2.9% from its December forecast of 2.67% and the end-2020 rate rising to 3.4% from 3.12%. That implies three rate hikes in each of those years.
The “longer-run” estimate for the fed funds rate also edged higher, hitting 2.875% compared to 2.75% in the previous estimate. Although these are small changes they are still significant: It is the first time the estimates have gone up since the onset of the financial crisis.
The dots plot
Source: Bloomberg. Data as of 3/21/2018.
Notes: The FOMC Dots Median reflects policymakers’ expectations for interest rates. The Fed Funds futures rate is what investors expect the fed 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.
The Fed’s adoption of a more “hawkish” tone may have been prompted by the fiscal stimulus coming from tax cuts and the recent budget, which increases federal government spending. First quarter gross domestic product (GDP) growth data have actually been soft, but the Fed’s post-meeting statement noted that “the economic outlook has strengthened in recent months.”
Consequently, the Fed upgraded its estimates for economic growth and inflation expectations for 2018 and 2019. The median estimate for GDP growth for 2018 was raised to 2.7% versus 2.5% previously, while the 2019 estimate was increased to 2.4% from 2.1%. The employment outlook is also positive. The projections were for the unemployment rate to drop to 3.6% next year.
However, despite the optimism about growth and unemployment, the Fed’s inflation estimates barely increased. The Core Personal Consumption Expenditures deflator (or PCE, the Fed’s favored measure of inflation) is still projected to end 2018 at 1.9% and nudge up to 2.1% next year, which would finally get it above the Fed’s 2.0% target.
Source: Federal Reserve Board, 3/21/ 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.
The market’s reaction was mild, with long-term bond yields increasing modestly in response to the expectations for stronger economic growth, lower unemployment and inflation moving higher.
We believe 10-year Treasury yields can continue to move higher, possibly as high as 3.25% from 2.88% following the meeting, in response to these prospects, along with the potential for Fed policy to lean toward more rate hikes in this cycle than previously anticipated. Long-term rates are to a large degree a function of the expected path of short-term rates plus a risk premium. With expectations for short-term rates to end the cycle at a higher level, then long-term rates are likely to adjust accordingly. Over the course of the cycle, however, the yield curve is likely to flatten further. As the Fed hikes rates, inflation and growth expectations tend to decline, limiting the rise in longer-term bond yields.
We continue to suggest that investors limit the average duration in their portfolios to the short to intermediate term to mitigate the impact of rising interest rates.
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