US Federal Reserve – Lift off!

Economic issues

• US Federal Reserve meeting: The Federal Reserve policymaking committee – the Federal Open Market Committee (FOMC) – has decided to raise interest rates for the first time in nine years. The funds target rate was lifted to 0.25%-0.50% in a unanimous decision.
• “The Committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.”
• The FOMC statement was more dovish than markets expected and the timing of future rate hikes will be data dependant. “The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.”

What are the implications for investors?

• The US central bank – the Federal Reserve – held its regular policy-setting meeting over Tuesday and Wednesday. But the meeting this time round took on much greater importance. For the first time since June 29 2006, the US Federal Reserve elected to lift interest rates.
• Over the past year US stock markets had been addicted to cheap money and essentially held the Federal Reserve to ransom every time there was a discussion on the possibility of a lift in US rates. It is encouraging that now investors have finally accepted and embraced the lift in interest rates from emergency levels.
• The decision to lift rates is actually a positive event for the US economy. It effectively signals that the crisis is finally over and the economy is on a credible recovery path and heading back to “normal”. The US economy is in good shape with firm economic growth and the unemployment rate having fallen to a 7-year low of 5.5 per cent.
• Interestingly the rate hike timing is right from an inflation perspective. While the continued decline in energy prices is keeping a lid on headline inflation, there are now clear signs that the core consumer price index (excluding food & energy) is lifting. Core inflation lifted for the third consecutive month, up by 0.2 per cent in November. The annual core inflation rate has now lifted to an 18-month high of 2.0 per cent. Of course the Fed’s preferred inflation measure – the core private consumption deflator – is still subdued, holding at an annualised rate of 1.3 per cent. But it should lift over the coming year, particularly as the commodity price effect fades.
• The next question is how quickly do interest rates rise? And that question was answered as it best could be at the press conference following the FOMC meeting. Federal Reserve Chair Janet Yellen emphasised that the Fed will be “patient”. Rate hikes will be “gradual”, data dependant and more importantly as the FOMC statement confirmed “the Committee will carefully monitor actual and expected progress toward its inflation goal.”
• Importantly it needs to be considered that the new “normal” federal funds rate may be a lot lower than in the past near 2 per cent but the Fed won’t know that for some time after the rate hiking process begins.
• Financial markets have been especially volatile in recent months as the lift-off point for interest rates has come into focus. The hope is that period of uncertainty ends with the decision to lift rates. Now that the US is on the path of interest rate ‘normalisation’ investor focus should return to economic fundamentals, provided the Fed assures investors both as to the state of the economy and the future path of interest rates.