Three hikes expected in 2017 as Fed follows through

Three, two, one, liftoff—and now with an extra Fed hike in the forecast for 2017.

As expected, the U.S. Federal Reserve decided to raise the target range for the federal funds rate from 0.25-0.5% to 0.5-0.75%. The hike in interest rates was the first time in a year and only the second time since 2006.

“The FOMC doesn’t seem to have caught a case of Trump fever just yet,” Avery Shenfeld says in a note. “That said, there is some optimism built into the outlook, as the ‘dot’ forecast now projects one more rate hike in 2017 than was previously the case in order to keep growth at essentially the same pace as previously projected.”

Shenfeld says “the higher dot forecast” will have markets adding a bit to expectations for further hikes. “We still see 5 quarter point hikes over the next two years, but now see three in 2017 and two in 2018 vs. our earlier call of two and three, seeing the Fed being a bit more preemptive in anticipation of some fiscal stimulus.”

In its December 14 statement, the Fed says economic activity will expand at a moderate pace with strengthening labor market conditions. It forecasts inflation of 2% over the medium term “as the transitory effects of past declines in energy and import prices dissipate and the labor market strengthens further.”

The Fed did not change its stance on risks to the U.S. economy. “Near-term risks to the economic outlook appear roughly balanced,” it says, reflecting its previous statement.

Brian Coulton, chief economist at Fitch Ratings, adds in a note that the upward revision to the 2017 Funds rate projection suggests more confidence that the Fed will pick up the pace of policy normalization in 2017 and 2018.

“But the subsequent rise in the dollar and the pick-up in bond yields have not warranted a sufficient tightening in credit conditions to stay the Fed’s hand again,” Coulton writes.

What led to the hike?

President-elect Donald Trump’s plans for tax cuts and infrastructure spending have led investors to expect that inflation will pick up in coming months.

The economy, after growing at an anemic annual rate of 1.1% in the first half of this year, accelerated to a 3.2% pace in the July-September quarter. That pickup has lifted hopes that the economy will keep rising, fueled by steady hiring gains. The unemployment rate is at a nine-year low of 4.6%.

“The decision to raise rates is a vote of confidence in the economy. But it was anticipated in markets and will likely have a low impact on market rates. There will likely be modest changes,” Fed Chair Yellen says at a news conference on Wednesday.

“Certainly it would be desired to have tax policies that [help to improve] productive capacity and spur business investment,” Yellen says, referring a weak spots in the economy. The Fed isn’t behind the curve in raising rates, Yellen says, arguing it’s on a stable path.

While fiscal policy isn’t necessary to ensure an improving economy, it does support productivity growth. Congress also has to take into account a rising debt-to-GDP ratio for the country as the population ages, one of many considerations in the government’s fiscal policy decisions.

“The message to fiscal authorities is that ‘what fiscal policy gives, monetary policy will take away,'” TD economist James Marple writes in a note. “Given the proximity of the labor market to full employment, any additional upward pressure on economic growth from fiscal stimulus will be met with a faster pace of rate hikes. As such, the Fed appears to be of the view that employment gains will slow considerably in the coming years.”

Projections

In today’s Fed statement, the central bank’s median economic projections call for 1.9% GDP growth in 2016, 2.1% growth in 2017, 2% growth in 2018 and 1.9% in 2019. Over the longer term, the Fed calls for 1.8% growth.

Plus, in the month since Trump’s victory, investors have sent stock prices surging to record highs and driven up bond yields. The markets have calculated that Republican control of Congress will enable Trump to cut taxes, ease regulations and accelerate infrastructure spending—and that higher economic growth, inflation and corporate profits will result.

But the Fed’s action Wednesday should have little effect on mortgages or auto and student loans. The Fed doesn’t directly affect those rates, at least not in the short run. However, rates on some other loans (notably credit cards, home equity loans and adjustable-rate mortgages) will likely rise soon, though only modestly. Those rates are based on benchmarks like banks’ prime rate, which moves in tandem with the Fed’s key rate.

Mortgage rates have been surging since Trump’s election victory last month on expectations that his economic program will accelerate economic growth and inflation.

On Trump’s promises to loosen financial regulations, Yellen says regulatory burdens on smaller banks and institutions should be reduced, but that it was important to end too-big-too-fail approaches. The Fed has suggested ways to tweak the Volcker Rule in discussions with Congress, but “it’s important to keep the rule in place,” Yellen says.

Inflation

Martin Crutsinger of The Associated Press reports some Fed watchers expect faster growth to lead the central bank to shift its focus from trying to energize the economy to considering ways to counter the risk of too-high inflation. On that assumption, some are revising their forecasts for Fed rate hikes in 2017.

For one thing, Trump’s economic program still must win congressional approval and could undergo significant change along the way.

And, last month after Trump’s election, Yellen told a congressional committee that Fed officials would be monitoring Congress’ actions and “updating our economic outlook as the policy landscape becomes clearer.”

Other Fed officials have endorsed that wait-and-see approach.

Voting for Wednesday’s FOMC monetary policy action were: Janet Yellen, chair; William C. Dudley, vice-chairman; Lael Brainard; James Bullard; Stanley Fischer; Esther L. George; Loretta J. Mester; Jerome H. Powell; Eric Rosengren; and Daniel K. Tarullo.