Fed Hikes, but Some Rates Veer Lower

Unless something extraordinary occurs, it will probably pass on this meeting and have a lively discussion at the March meeting, where a second rate hike is more likely.

When Reuters last polled primary dealers, the median forecast was for a fed funds rate of 1.125% at the end of that year.

Was this decision justified?

Despite the start of rate hikes, it’s still hard to find enough income.

Economic data have been pointing in this direction for some time now. Specifically, the Taylor Rule implies the Fed should be now targeting a rate of about 1%, based on inflation of 1.5% to 1.8% and GDP underperformance of about 2.5% to 3%.

So what will happen next?

Federal Reserve Chair Janet Yellen closes her notebook after holding a news conference in Washington, Wednesday, Dec. 16, 2015, following an announcement that the Federal Reserve raised its key interest rate by quarter-point, heralding higher lending rates in an economy much sturdier than the one the Fed helped rescue in 2008.

With oil prices likely to stay low through next year, those expectations may be optimistic. And the Fed’s first hike may not slow them.

The Federal Open Market Committee, the branch of the Federal Reserve that controls monetary policy, started the upward move. In all, there is plenty of competing ideas surrounding the exact rule and how (or whether) the Fed should actually follow the rule or use it more as a guide. This week’s move takes the new target from 0%-0.25% to 0.25%-0.5%.

After the rate hike, attention turned immediately to the likely timing of the next move. There is no guarantee that any strategies discussed will work under all market conditions.

The dot plot, which shows the target range for the federal funds rate, says otherwise.

The move sent the dollar up to a two-week high against a basket of leading currencies, while spot gold dipped as much as 1.3 percent to a session low of $1,058.44 an ounce and was down 1.2 percent at $1,059.76 by 1405 GMT, less than $15 above a near-six-year low hit earlier this month. The European Union and Japan are still engaged in quantitative easing and are keeping rates near zero or in the case of the EU, in negative territory. But both central banks then continued to raise interest rates until 2006-7. Doing so would wreak chaos upon the entire financial system.

Europe’s main indices rallied on Thursday after the USA central bank ended months of uncertainty surrounding interest rate policy.

The Fed drained $105 billion through reverse repos at a 0.25 percent rate, up from the $102 billion it borrowed Wednesday at the old 0.05 percent rate.

A similar theme has also played out in the sterling exchange rate against the euro, although to a lesser extent.

Having said this, let’s look at what history tells us about rate hikes and how they affect the market in the long run. There is reason to hope, however, that the Fed will be cautious about future increases.

Emerging markets have had a series of bad press over the past year. Some observers, such as former Federal Deposit Insurance Corporation Chair Sheila Bair, believe that the program threatens financial stability. In addition, it is the first increase in nearly ten years. “I liken it to a student who pulls an all-nighter”, he said.

Only one of the nine MPC members – Ian McCafferty – is voting for an increase in United Kingdom interest rates. We do not expect any major impact on India.

Markets went up again when the hike was finally announced this week. Yes, rates will still be low by historic standards.

One is inflation. It might not have reared its head so far, but sooner or later it will. Combine a recovering economy with a tightening labor market and super low costs on borrowing, and pretty soon the party could get out of hand.

We have a lot of evidence on how wrong expectations have been.

Additionally, the USA economy has dramatically changed over the past several years, with structural factors (largely the result of technological innovation and shifting demographic trends) influencing it in a manner that makes comparisons to past rate hiking cycles less relevant. “It is a good time to invest overseas”.