US Federal Open Market Committee interest rate announcement
Yesterday evening, the Federal Reserve (the ‘Fed’) announced a rise in US interest rates for the first time in 9 years. While this was widely expected, having been continually signposted by the Federal Open Market Committee’s (‘FOMC’) members for some time, it finally removes any lingering uncertainty as to when the process of monetary policy normalisation would begin. Commensurate with the move, the Fed also pledged to continue to re-invest maturing securities on its balance sheet until the normalisation process is well underway.
Importantly, there were no dissenters in voting a 0.25% hike through, underscoring the decisiveness of the Fed’s action. However, FOMC Chair Janet Yellen also explicitly stated that investors should not overestimate the move’s importance, as monetary policy remains highly accommodative and it will take some time before the impact of the hike is felt.
Over the last few months, expectations of a first rate rise have risen and fallen in line with the strength of US domestic economic data and the stability of global markets. As such, the Fed made a point to recognise that the hike was reflective of its confidence in the economy and the fact that it considered overseas risks to have diminished. Furthermore, it noted that the risks to the economic outlook were “balanced”, that there remains some room for further improvement in the labour market and that recent softness in inflation has been due to transitory factors. However, it also noted that survey measures of longer-term inflation expectations have edged down.
In our view, the FOMC’s forward guidance as to the longer-term pace of tightening has always been more important than the timing of the first hike. In this regard, its expectations have been more hawkish than those of the market for some time. Following last night’s announcement this remains the case, with the FOMC members’ median 2016 rate-rise expectations unchanged; they still expect to implement four 0.25% rises in 2016, one for every two Fed meetings, while the market has priced in only two 0.25% hikes next year. However, the FOMC did reduce its median expectation of the terminal rate from 3.75% to 3.5%.
We believe that the pace of tightening will be slow and gradual, reflecting a steady improvement in both the US economic backdrop and the broader global outlook. The Fed has been determined to start normalising monetary policy for some time and while its actions are merited by the current economic backdrop, it will have to remain vigilant and flexible to ensure that it does not stifle the US recovery. Many economic headwinds remain, including global deflationary forces, and an aggressive path of tightening may be considered a policy error by the market. Having said this, Janet Yellen again caveated that changes to monetary policy would be contingent on the Fed’s mandate criteria being adhered to, while she also indicated that future rate rises are unlikely to be evenly spaced as the US economy is not likely to progress in a uniform manner.
So far, it seems the Fed has been successful in telegraphing its decision. A very short-lived dip aside, the market’s initial reaction to the news was rather muted, with volatility subdued despite lower-than-average market liquidity. Since, asset markets have rallied, with US, Asian and European equities all making decent gains and credit spreads tightening. The dollar has also strengthened slightly and, encouragingly, the US government bond market has shown resilience. In our view, this reflects a bolstering of the Fed’s credibility and an improvement in investor sentiment that has been driven by greater clarity in the monetary policy outlook.
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