Why the Fed Raised Rates and What May Come Next | Capital Group

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Why the Fed Raised Rates and What May Come Next

The Federal Reserve’s decision to raise its key short-term interest rate Wednesday was widely expected given the continuing growth in the U.S. economy. The central bank boosted the federal funds rate by a quarter point to a range of 0.75% to 1.00%. Given the economic progress, the Fed said it may boost rates twice more this year. However, that depends heavily on economic and financial trends, and it’s possible that rates could rise more slowly if conditions tighten. Regardless of how many hikes ultimately come, rates will remain low by historical standards.

Several reasons lay behind the central bank’s decision to raise rates. First, financial conditions such as asset prices, which can influence economic behavior and the direction of the economy, have eased since late last year. The broad dollar index is roughly unchanged, 10-year Treasury yields are slightly lower, credit spreads are tighter and the S&P 500 Index is up nearly 6% since the Fed raised rates in December.

Beyond that, the economy has continued to make progress toward the Fed’s goals of full employment and price stability. The labor market continues to be strong, with the economy adding an average of 180,000 jobs per month over the past six months. This has kept the unemployment rate below 5%, which is already equivalent to the Fed’s long-run forecast for the so-called non-accelerating inflation rate of unemployment.

As for price stability, inflation is gradually rising toward the Fed’s 2% target. The January reading of the annual change in the core personal consumption expenditures (PCE) price index rose to 1.74%, ahead of the Fed’s end-of-2017 forecast of 1.7% provided by its December projections.

Aggressive Rate Hikes Face Headwinds

Looking ahead, additional rate hikes will depend on the evolution of financial conditions and continued progress toward the Fed’s goals. If financial conditions remain easy and the economy exceeds Fed expectations there may be two more quarter-point hikes this year.

However, it is possible that financial conditions could tighten once the market anticipates a faster pace of rate increases, which would allow the Fed to hike more slowly. To illustrate this point, financial conditions tightened significantly after the central bank raised the fed funds rate in December 2015 and surprised the market by forecasting four hikes for 2016. In the end, the Fed was only able to hike once in 2016 as tighter financial conditions led the Fed to be more cautious about a further removal of monetary accommodation.

As a reminder of how we got here, the Fed took a number of aggressive monetary policy measures in 2008 to cope with the global financial crisis and ensuing recession. These steps included cutting short-term interest rates to near zero and implementing three rounds of quantitative easing in the years that followed.

The Fed ended its quantitative easing program in October 2014, and in December 2015 raised rates for the first time since 2006. The central bank raised rates by another 25 basis points last December and projected three additional hikes for 2017.

By hiking rates on Wednesday, Fed officials gave themselves greater flexibility to adjust policy the remainder of this year and reduced the risk of “falling behind the curve,” a concern that several officials have mentioned in the past.