The Federal Reserve has raised short-term interest rates for the second time in a decade and forecast a faster pace of tightening next year as it responded to a US economy that is gathering momentum and the prospect of further stimulus from Republican tax cuts.
With the US on the cusp of full employment and inflation gradually approaching the Fed’s target, the central bank raised the target range for the federal funds rate by a quarter-point to 0.5-0.75 per cent, as widely expected by financial markets. The Fed’s policymakers pencilled in a median projection of three quarter-point increases for 2017, up from two previously.
The unanimous decision to lift rates came in the Fed’s final meeting before president-elect Donald Trump is due to take office, and as Republicans contemplate tax-cutting plans that could add further fuel to the recovery.
In bond markets, the yield on the policy-sensitive two-year Treasury note jumped to the highest level since 2009 after the announcement, signalling the markets’ expectation of higher inflation. The yield, which moves in the opposite direction of the price, was up 5.1 basis points to 1.2104 per cent.
In its post-meeting statement, the Fed said it was raising rates in view of “realised and expected labour market conditions and inflation”. It reiterated its guidance of “gradual” increases.
It added that policy remained “accommodative” and that this would support “some” further strengthening of the labour market – words that suggested the central bank thinks it is closer to maximum employment.
The Fed has repeatedly overestimated the pace at which it would be able to tighten policy, and spent 2016 engaged in a gloomy rethink of the economy’s longer-term growth outlook.
But market expectations of the growth and inflation outlook have been transformed by the prospects of a fiscal stimulus by the next administration and Congressional Republicans, prompting markets to anticipate a steeper pace of Fed tightening.
Even before any fiscal expansion by the Republicans, recent data suggest the Fed is already closing in on its employment and inflation goals. Steady hiring has driven the unemployment rate to just 4.6 per cent as of November, below Fed policymakers’ median estimate of its long-term rate. Inflation as measured by the personal consumption expenditures price index, excluding food and fuel, is at 1.7 per cent, not far from the Fed’s 2 per cent target.
Fed policymakers’ latest so-called dot plot projections suggest they expect rates to rise faster than the glacial, once-a-year pace set in the past two years.
The Fed’s new projection for 2017 had the median interest rate centred at 1.375 per cent, compared with 1.125 per cent in the September forecast. The median projection for the longer-term interest rate was lifted to 3 per cent, reversing its previous, seemingly inexorable decline.
