Last Wednesday, the Federal Reserve raised its key interest rate by 0.25%. That decision surprised no one – at least no one in the financial markets. Hours before the announcement, the CME Group’s FedWatch Tool, which calculates the chance of interest rate moves based on Fed futures contracts, showed a 97.1% probability of a quarter-point hike.
The central bank made its decision “in view of realized and expected labor market conditions and inflation.” Equity investors reacted with some degree of calm: thirty minutes after the news broke, the S&P 500 was down less than 15 points. As for Treasuries, the yield on the 2-year note spiked and hit a peak unseen since 2009 within a half-hour of the release of the Federal Open Market Committee’s statement.
Any other decision could have thrown market participants for a loop. There is no such thing as a “sure thing” on Wall Street, but a December interest rate hike looked like a lock to many analysts. Fed officials had hinted that a move was near, and with economic indicators broadly improving, the Federal Open Market Committee had little choice but to follow through.
If the Fed had left rates unchanged Wednesday after all of its recent signals, it would have lost credibility. Any inaction would have implied a lack of faith in the economy and uncertainty about the next presidential administration. A half-point increase in the federal funds rate would have come as a hawkish surprise. Either scenario might have upset the bulls.
What does the Fed’s latest dot-plot forecast indicate? The central bank now sees a trio of quarter-point rate hikes occurring in 2017, as opposed to two in its prior projection. If carried out, those increases would take the target range on the federal funds rate to 1.25-1.50% by the end of next year. If the Fed gradually raises its key interest rate in 2017 to try and maintain its target inflation rate, short-term interest rates will be impacted, and both consumer spending and business spending will be affected. The question is whether Wall Street will take such tightening in stride.
This quarter-point move is less momentous than it may seem. Banks, borrowers, bond issuers, and investors influence medium-term and long-term interest rates much more profoundly than the Fed does. The central bank has boosted the federal funds rate for overnight lending just twice in 12 months, yet interest rates have been rising anyway. On July 8, the yield on the 10-year note was down at 1.37%. On December 13, it hit 2.48%.