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Fed Finally Agrees to Small Rate Hike

Twelve months after the Federal Reserve last raised interest rates, the board finally agreed to raise rates again on Wednesday, December 14, increasing the federal funds target rate by 25 basis points, to a new range of 0.50% – 0.75%. 

With employment growth continuing (unemployment was at a nine-year low of 4.7% in November, according to the U.S. Department of Labor) and retail sales at a fairly strong level, the Fed finally felt the economy was strong enough to absorb a small rate hike.

Federal Reserve Board Chair Janet Yellen had foreshadowed an eventual rate hike in August when she said "in light of the continued solid performance of the labor market and our outlook for economic activity and inflation, I believe the case for an increase in the federal funds rate has strengthened in recent months."1  

When the year began, many analysts believed the Fed would raise rates two or three times during 2016, but manufacturing and production levels have been tepid, and a strong dollar has made competition in the global market place stiffer for U.S. businesses.

Gross domestic product (GDP) growth was also fairly weak throughout much of the year, although it has been stronger in recent months. GDP grew at an annualized rate of 3.2% in the third quarter, according to a revised estimate released Nov. 29 by the Bureau of Economic Analysis (BEA).

However, that figure may be somewhat misleading since net trade, which accounted for 0.8%, was driven by a surge in soybean exports due to a drought in South America, and inventory build-up added 0.6%.  Neither development is considered to be sustainable.

We believe this small rate hike may be beneficial to net savers without adversely affecting the economy or consumer spending – particularly if the job market remains strong.

Bank savings accounts and money markets have been paying in the range of 0.00% to 0.01%, so traditional savers are getting essentially nothing for their dollars.

The biggest downside to the rate hike may be that it could further strengthen the U.S. dollar. The dollar had already gained against most of the world's currencies in November, and could move up again as a result of the Fed hike.  A strong dollar makes imports cheaper, but makes American goods and services less competitive abroad.

Going forward, we think the Fed would like to move to "normalize" rates with further rate hikes in 2017, but may still take a slow, cautious approach to avoid weakening the economy or further strengthening the dollar.

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