Fed Tightening Continues

 In Market and Investment Insights

Key Takeaways

  • On Wednesday, the Federal Reserve (Fed) raised its benchmark rate by 25 basis points and said the path for rate hikes could steepen starting next year
  • However, although a strengthening economy and robust job market might warrant additional hikes, the Fed noted that inflation did not appear to be on the cusp of accelerating
  • As such, we believe the central bank will continue to tighten monetary policy gradually in the near term, helping keep Treasury yields range-bound

As expected, the Federal Reserve (Fed) raised its benchmark rate by 25 basis points on Wednesday. It was the first increase since Jerome Powell took over as Fed chairman this year, and the sixth quarter-point hike since the central bank began normalizing monetary policy. The Fed’s target rate now ranges from 1.50% to 1.75%.

More notable, however, was a change in the Fed’s outlook for future rate increases. A growing number of Fed officials now say a total of four hikes may be needed in 2018, rather than the consensus estimate of three. In addition, the median estimate for the benchmark rate rose to 2.9% by the end of 2019 and 3.4% by the end of 2020, up from 2.7% and 3.1%, respectively, the last time the Fed met.

During the central bank’s post-meeting news conference, Mr. Powell cited an improving economy and strong job market as reasons for the rate hike. He also said that the Fed’s estimates for future growth and unemployment had improved. Further, the outlook for core inflation also climbed – but only modestly, to an estimated 2.1% next year, up from 2.0% in earlier forecasts. Asked whether inflation could take off, Mr. Powell said data did not suggest that “we’re on the cusp of an acceleration of inflation.” Markets seemed to agree, with Treasurys rallying after briefly selling off following the Fed’s announcement.

We believe the Fed’s outlook suggests the path to policy normalization should continue to be measured. Although inflation is trending higher, we note that powerful forces such as an aging population and the digitalization of the global economy should help keep prices in check. Also, the tightening labor market has yet to result in a sustained increase in wages, while economic growth could face headwinds such as trade barriers and the rising deficit. As such, our base case is for the Fed to make a total of three quarter-point hikes in 2018, and for the 10-year Treasury yield to end the year at 3% to 3.5%.

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Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bps = 1%.