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Fed Hikes Rates for Second Time This Year

The Federal Reserve Board (Fed) voted Wednesday to raise rates for the third time in the past seven months, following an eight-year stretch during which the Fed adjusted rates only once.

With unemployment at a 16-year low, corporate earnings on the upswing, and consumer spending edging up, the Fed agreed to raise the federal funds target rate by 25 basis points (0.25%) to a new range of 1.00% to 1.25%.

Federal ReserveHowever, new inflation and retail sales figures released Wednesday prior to the Fed’s announcement both showed surprising declines. Retail sales in May were down 0.3% from the previous month, according to the U.S. Department of Commerce, and consumer prices were down 0.1% in May, according to the U.S. Department of Labor Consumer Price Index report, dragging the rate of inflation down from 2.2% to 1.9%.

This unexpectedly soft data stirred a rally in the bond market Wednesday morning, driving down market interest rates on 10-year U.S. Treasuries by 10 basis points to 2.11% – the lowest yield since November 2016.  

This was the second rate hike of 2017, following a 0.25% increase on March 15. The Fed also raised rates by 0.25% in December 2016 and December 2015.  Prior to that, there had not been a Fed move since the Great Recession when rates were cut from 5.25% to 0.00% during a 16-month period that ended with the final cut in December 2008.  The rate stayed at (or near) 0.00% for seven years until the first rate hike in December 2015.

exhibit
      1The Fed has been more comfortable raising rates recently because of several economic fundamentals. U.S. employers have added new jobs for 80 consecutive months as the unemployment rate tumbled to just 4.3% in May – the lowest rate since 2001.  Retail sales had been rising prior to Wednesday’s U.S. Department of Labor Consumer Price Index report, and corporate earnings in the first quarter of 2017 were growing at the highest rate since 2011, according to FactSet.

Gross domestic product (GDP) growth was slow through the first quarter – a 0.7% annualized growth rate – but the consensus projection for real GDP growth for all of 2017 is 2.2%, according to the June 10 Blue Chip Economic Indicators report.

According to the Fed statement from its meeting, Fed board members expect at least one more rate hike this year. However, the bond market’s reaction to the new inflation and retail sales numbers suggests that bond analysts are skeptical that there will be any further rate hikes in 2017. 

We believe there could be at least one more rate hike this year if the economy strengthens. Federal Reserve Board Chair Janet Yellen, had announced earlier in the year that the Fed hopes to increase rates gradually over the next two to three years if the economy remains solid.  “We think gradual increases in the fed funds rate will be appropriate,” noted Yellen.

Of equal importance to the Fed’s rate hikes has been its recent policy change regarding monetary policy. The Fed has been reducing its bond purchases in order to tighten monetary policy, although it’s unclear how much further they will reduce bond purchases in the future – and how that policy change will affect the economy and inflation.

The next Fed meeting is scheduled for July 25 to 26.

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