Fed Meets Market Expectations with Rate Hike

The U.S. Federal Reserve raised rates for the first time after nine and a half years. The interest rate rise by 25 basis points is a validation of the U.S. economic recovery after the crisis of 2008. The hike had been highly anticipated and its final arrival did not cause the USD to appreciate beyond current levels.

There was a lot of anxiety from investors ahead of the central bank rate announcement after the European Central Bank (ECB) had failed to communicate its intentions to the market. The Fed delivered as promised and little more. The market’s expectations were met, but not exceeded, giving no boost to the USD. The “transitory factors” affecting the economy have taken longer than expected to work themselves out and have in fact forced the Fed to adopt a more gradual pace of rate hikes in 2016.

The rhetoric from the Fed statement remains accommodative, but its data dependant guidance will continue to bring uncertainty and volatility in 2016.

Rate Statement

The language from the December Federal Open Market Committee (FOMC) rate statement saw plenty of changes besides the federal funds rate target increase to 1/2 percent. The market had already priced in the first rate hike in nine and a half years so the focus was going to be on the additional language and the insights into Fed actions in 2016.

The statement emphasized on multiple occasions the employment recovery and labeled the reduction of slack as “appreciably”. Wage growth concerns remain as there is very little inflationary pressure.

The Fed added the line after its dual mandate:

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.

Data dependency will remain, but the use of the word gradual hints at a slower pace that initially communicated via the economic projections.

Economic Projections

Fed officials forecast a median of 1.375 percent in 2016. This marks a lower target hinting at a slower pace of rate hikes. Given that 2016 is an elections year the Fed will refrain from monetary action close to the elections which leaves 3 to 4 rates hikes in the year, or less if the U.S. economy recovery hits a snag.

Fed officials are not optimistic about a return to 2 percent, until 2018. The inflation expectations in the new projections is 1.6 percent, compared to 1.7 percent in September.

Press Conference

Fed Chair Janet Yellen got a chance to explain the decision by the members of the FOMC to raise rates in her reading of prepared remarks followed by a round of questions from the financial press. Chair Yellen pushed forward the idea that the U.S. provides strength to the global economy. Employment has recovered, but weakness remains in particular wage growth is lower due to lack of inflationary pressure. Yellen asked market participants to move beyond this first rate hike, as the central bank will remain vigilant and depend on data for the basis of its monetary policy decisions. Yellen made sure to communicate that “gradual” does not mean mechanical when talking about future interest rate hikes.

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Alfonso Esparza

Alfonso Esparza

Senior Currency Analyst at Market Pulse
Alfonso Esparza specializes in macro forex strategies for North American and major currency pairs. Upon joining OANDA in 2007, Alfonso Esparza established the MarketPulseFX blog and he has since written extensively about central banks and global economic and political trends. Alfonso has also worked as a professional currency
trader focused on North America and emerging markets. He has been published by The MarketWatch, Reuters, the Wall Street Journal and The Globe and Mail, and he also appears regularly as a guest commentator on networks including Bloomberg and BNN. He holds a finance degree from the Monterrey Institute of Technology and Higher Education (ITESM) and an MBA with a specialization on financial engineering and marketing from the University of Toronto.
Alfonso Esparza