Fed Raises Rates After Seven Years at Zero, Expects ‘Gradual’ Tightening Path
Fed-funds rate moved up to range between 0.25% and 0.50%
The Federal Reserve said it would raise its benchmark interest rate from near zero for the first time since December 2008, and emphasized it will likely lift it gradually thereafter in a test of the economy’s capacity to stand on its own with less support from super-easy monetary policy.
Fed officials said they would move up the federal funds rate by a quarter percentage point on Thursday, to between 0.25% and 0.5%, and would adjust their strategy as they see how the economy performs. At these low rates, they added, policy remains accommodative.
“The [Fed] expects economic conditions will evolve in a manner that will warrant only gradual increases in the fed funds rate,” the Fed said in a statement following its two-day meeting. To hammer home this point, officials added in a second place in their statement that they anticipated “gradual adjustments” in rates.
Fed Chairwoman Janet Yellen won a unanimous vote.
New projections show officials expect their benchmark rate to creep up to 1.375% by the end of 2016, according to the median projection of 17 officials, to 2.375% by the end of 2017 and 3.25% in three years. That implies four quarter-percentage-point interest rate increases next year, four the next and three or four the following.
That is a slower pace than projected by officials in September and much slower compared to earlier series of Fed rate increases. In the 2004-06 period, for example, the Fed raised rates 17 times in succession, an approach Fed officials don’t intend to repeat. In September seven Fed officials believed the fed funds rate could rise to 3% or higher by 2017; now just four do.
When the Fed moves next will depend importantly on how inflation evolves. The Fed’s preferred measure of inflation has run below its 2% objective for more than three years. The central bank focused extra attention on the inflation outlook in its statement, saying it would “carefully monitor” actual and expected progress toward the goal. This point implied the Fed will be reluctant to raise rates again unless it sees inflation actually moving up. For now, officials said they were “reasonably confident” inflation would rise.
Ms. Yellen, in a speech and in testimony earlier this month, said a rate increase represented a vote of confidence in the U.S. economy after the deep 2007-09 recession and a long, often-disappointing recovery. Still, uncertainties abound about how markets and the economy will respond in the months ahead.
Any number of factors might throw the central bank off its plans. Persistently low inflation, a shock to the financial system or slowing growth from abroad could force the Fed to delay further rate increases or even reverse course. An unexpected acceleration in economic growth or inflation, or a new financial boom could lead officials to lift borrowing costs more quickly.
For the moment, however, Fed officials see an economy that has made enough progress to warrant a slow retreat from easy money. The jobless rate has fallen to 5% in November from 10% in 2009. Inflation has run below the Fed’s 2% goal for more than three years, but officials believe it will rise in 2016 as slack in the job market diminishes and oil prices stabilize.
“There has been considerable improvement in the labor market,” the Fed said.
Officials predicted the economy would expand at an annual pace between 2.4% in 2016 and 2.0% in 2018, in the process taking the expansion to a decade in length. They saw their preferred measure of inflation rising from 0.4% in 2015 to 1.6% in 2016 and then to 2% by 2018. The jobless rate is seen stabilizing at 4.7% during the next three years. These projections were largely in line with earlier estimates.
Whether other interest rates—on savings accounts, mortgages, car loans, credit cards, corporate loans and beyond—rise as well depends on how investors, businesses and households respond.
Stocks surged in the minutes after the Fed announcement, with the Dow Jones Industrial Average up by triple digits.
The market doesn’t always follow the Fed’s lead. Between 2004 and 2006, when the Fed raised its benchmark short-term rate 4.25 percentage points, yields on 10-year U.S. Treasury notes and corporate bonds and mortgage rates barely budged because of strong global appetite for U.S. securities.
Michael Lussier, chief executive of Webster First Federal Credit Union in Worcester, Mass., said banks and credit unions now could be slow to adjust rates on certificates of deposits and other savings accounts, potentially bad news for retirees looking for higher returns on their fixed income investments.
“You are not going to see an instant change in CDs on Thursday, that’s a guarantee,” he said in an interview ahead of the Fed’s release. A 12-month CD at First Federal yields 0.4%.
The central bank has been telegraphing the rate increase for months. In September it looked close to acting, but turbulence in financial markets and uncertainties about the global growth outlook, particularly in China, caused officials to hold off.
By moving now, the Fed could put new pressure on emerging markets, particularly corporate borrowers in these countries that took out U.S. dollar loans which have gotten more expensive as the dollar rises in value.
The junk bond market is already reeling. Yields on low-rate junk bonds have jumped from 6.61% at the beginning of the year to 8.79%. In the process investors have retreated from junk bond funds, a development that prompted Third Avenue Management LLC last week to suspend withdrawals, which added to investor anxiety about the sector.
To ensure it doesn’t disrupt markets too much, officials noted in their statement that they intended to keep their portfolio of mortgage and Treasury securities large for the time being, avoiding selling securities or letting them mature without rolling them over. It said it wouldn’t reduce its holdings until rate increases were “well under way.” The Fed has assets of $4.5 trillion and shrinking the portfolio could shake up markets.
The Fed’s rate increase goes into effect Thursday. That is when the central bank will begin moving two new levers. One is an interest rate it pays on deposits—known as reserves—which banks keep with the central bank. This rate will move to 0.50% from 0.25%. The other is a rate the Fed pays to money market mutual funds and others on trades known as overnight reverse repurchase agreements, or repos. That rate will move to 0.25% from 0.050%.
Officials expect their benchmark rate, the federal funds rate, which is what banks pay each other for overnight loans, to move toward the middle of the 0.25% to 0.50% channel it is creating with these two other rates.
Officials in 2014 set a $300 billion limit on the amount of reverse repo trades they would conduct with Wall Street firms to maintain the lower bound of the channel. In a technical step to ensure there are no constraints on getting rates where they want them, the Fed on Wednesday said it would lift that cap to around $2 trillion.
The central bank also raised the rate it charges banks on emergency loans, by a quarter percentage point to 1%.