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Will the Fed Keep Raising Rates if Inflation Stays Low?

Will the Fed Keep Raising Rates if Inflation Stays Low?

The Federal Reserve has been tapping the brakes on economic growth over the past 18 months, raising a key short-term rate several times in an effort to keep the economy from overheating.

However, the bond market isn’t convinced the Fed will continue to raise short-term interest rates. The futures market is assigning only about 30% chance of a rate hike later this year and has discounted very little increase in rates in 2018. 

The market’s skepticism has been fed by the persistence of low inflation. Can the Fed keep raising rates if inflation remains low or trends lower? 

Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research,  thinks the answer is yes. “More rate hikes are likely, because the Fed would like to get policy back to normal now that the risk of deflation has receded,” she says. 

That’s because with interest rates still very low, and the Fed’s balance sheet full of Treasury securities purchased in the years following the 2008-2009 financial crisis, the central bank has few tools to deal with a potential future economic downturn, she says. The Fed recently announced plans to begin reducing its balance sheet, and its economic projections suggest one more rate hike in 2017. 

The Fed is also likely to tighten policy because of concerns about asset-price bubbles developing, Kathy says. “Several Fed officials, including Fed Chair Janet Yellen, have indicated concern recently about high valuations in some markets, particularly stocks and high-yield bonds,” she says. 

Just because the Fed chair says markets are overvalued doesn’t mean those markets will go down. However, it could mean the market may be underestimating the Fed’s determination to raise rates. 

“The more the market underestimates the Fed, the riskier it gets,” Kathy says. “In the first half of the year, risky assets did very well. The strongest performing currencies were the Mexican peso and the South African rand. High-yield bonds and emerging market bonds also posted strong returns. That is not what usually happens when monetary policy is tightening in the world’s major economies.” 

The one thing that could stand in the Fed’s way would be a deterioration in the labor market, but that doesn’t seem likely any time soon, Kathy says. 

“It looks like the economy is in a self-reinforcing cycle where solid job growth leads to solid consumer spending, which is keeping the economy chugging along at a 2% to 2.5% pace” in terms of gross domestic product growth, she says. “It isn’t anywhere near the pace seen in previous expansions, but it seems to have momentum.”

What investors should consider now

Because longer-term bond yields tend to be more sensitive to interest-rate changes than shorter-term bonds, Kathy suggests keeping your average fixed income portfolio duration in the short-to-intermediate term for now. Limiting average duration to the three- to seven -year (as far out as seven to 10 years for municipal bonds) area provides exposure to most of the yield curve, while potentially limiting volatility, she says.

She also suggests sticking to high-quality bonds, for the most part. Investment-grade corporate and municipal bonds, along with Treasuries and certificates of deposit (CDs), should be less volatile than lower-credit-quality bonds like high-yield or emerging market bonds, Kathy says. 

Investors may also want to consider investment-grade floating rate notes, she says. Floaters, which have very short durations and pay income linked to short-term rates, may benefit from rate hikes by the Fed. Bank loans are also another option—but remember that these are considered aggressive income investments as they are high-yield and less liquid than most bonds, she says.

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.
  • Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.
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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.

Investing involves risk, including loss of principal. International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

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

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

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.

Currencies are speculative, very volatile and are not suitable for all investors.

Tax-exempt bonds, such as municipal bonds, are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax. 

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates. The most frequently reported yield curve compares the three-month, two-year, five-year and 30-year U.S. Treasury debt.

While the market value of a floating rate note is relatively insensitive to changes in interest rates, the income received is highly dependent upon the level of the reference rate over the life of the investment. Total return may be less than anticipated if future interest rate expectations are not met.

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

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