Why the Yellen and Fed Rate Hikes Are Favorable -- With More Hikes to Come!

If you were under the belief that the underlying economy was not yet strong enough to support an interest rate hike, note that the Federal Reserve has raised interest rates. Fed Chair Janet Yellen and the voting members of the Federal Open Market Committee (FOMC) have voted to raise the federal funds rate to a target range of 0.75% to 1.00%. This marked the first rate hike of 2017 and was only the third rate hike since the Fed took rates to a 0.00% to 0.25% target range during the early days of the Great Recession.

The FedWatch Tool had the odds of a fed funds target range of 0.75% to 1.00% pegged at 95% immediately before the official announcement. That was about 90% earlier in the week, but that was far less priced in even as recently as the end of February.

The FOMC’s vote was nine to one in favor of a rate hike. Neel Kashkari was the sole dissenting vote. The median forecast remains for three rate hikes expected in 2017 with a median funds rate of 1.40% at the end of 2017, followed by 2.1% at the end of 2018 and 3.00% at the end of 2019 and thereafter. The official statement on the rate hike said:

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 3/4 to 1 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.

While this is undoubtedly a more hawkish move after years of being excessively dovish, the reality is that the FOMC has been behind the rate hike curve for some time. Inflation has reached the 2.0% threshold on many counts, but perhaps not on all fronts. The official unemployment rate has been at or under 5.0% since mid-2015. Those meet the dual mandate of full employment and stable inflation.

What the public needs to also consider is that the Fed’s non-mandate concerns outside of its traditional focus have also been met. This includes international economic growth and the financial market growth.

One more issue that should be considered is that the National Debt Clock shows that the U.S. national debt was more than $19.9 trillion. That will be $20 trillion in the coming days or months. And as for the Fed’s own balance sheet, the week ending March 8 had a balance of securities held outright of more than $4.24 trillion. Of that, there were over $2.46 trillion held in Treasury notes and bonds and over $1.76 trillion held in mortgage-backed securities.

As far as how the Fed will handle its balance sheet and reinvesting principal, the statement said:

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

It has been no secret that the stock market has surged since the election in November. Not only did the Dow break above 20,000 in 2017, it even went above 21,000 briefly, though it was at 20,883 minutes before the official FOMC rate hike was announced. That represents close to a 14% gain from the Dow’s closing price of 18,332.74 on election day. The yield of the 10-year Treasury was last seen at 2.58%, up from 1.86% on election day.

The market pundits and 24/7 Wall St. have by and large been calling for rates to finally be lifted for a while now. Our own view has been that the rate hikes could have started earlier in 2017, but the dovish trends had been intact instead. Getting a prediction right is one thing, but how the Fed handles rising rates and the economy in the months and quarters ahead is what will really matter more than just one rate hike.

It is also important to keep an old adage in mind: Be careful what you wish for, you just might get it.