Fed Ends Zero-Rate Era; Signals 4 Quarter-Point Increases in 2016

Fed Ends Zero-Rate Era, No Floor Under Interest Rates
  • Fed monitoring `actual and expected' progress on inflation
  • Officials see economy warranting `only gradual' increases

The Federal Reserve raised interest rates for the first time in almost a decade, a widely telegraphed move that Chair Janet Yellen said would be followed by “gradual” tightening as officials watch for evidence of higher inflation.

The Federal Open Market Committee unanimously voted to set the new target range for the federal funds rate at 0.25 percent to 0.5 percent, up from zero to 0.25 percent. Policy makers separately forecast an appropriate rate of 1.375 percent at the end of 2016, the same as September, implying four quarter-point increases in the target range next year, based on the median number from 17 officials.

“The economic recovery has clearly come a long way, although it is not yet complete,” Yellen told a press conference following the conclusion of the FOMC’s two-day meeting in Washington. “The committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen.”

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The increase draws to a close an unprecedented period of record-low rates that were part of extraordinary and controversial Fed policies designed to stimulate the U.S. economy in the wake of the most devastating financial crisis since the Great Depression. The FOMC lowered its benchmark rate to near zero in December 2008, three months after the collapse of investment bank Lehman Brothers Holdings Inc. and 10 months before unemployment in the U.S. peaked at 10 percent.

Inflation Outlook

"The one phrase that I think is notable is that the committee is confident that inflation will rise, and that was the key criterion that changed," said Guy LeBas, managing director and chief fixed-income strategist at Janney Montgomery Scott LLC in Philadelphia. 

The Standard & Poor’s 500 Index of U.S. stocks jumped 1.5 percent to 2,073.07 in New York, rising for three consecutive days for the first time since October while erasing losses for the year. The dollar fluctuated against the euro after the decision, falling as much as 0.7 percent. It later recouped losses, climbing 0.3 percent to $1.0902 per euro as of 4:14 p.m. in New York. 

While the vote was unanimous, the rate forecasts show that two officials among the full group of voters and non-voters saw no rate increases as appropriate in 2015, without identifying them.

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“The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the FOMC said. “The actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”

Balance Sheet

The FOMC said it expects to maintain the size of its balance sheet “until normalization of the level of the federal funds rate is well under way.”

The quarter-point increase in the target fed funds rate, the overnight interbank lending rate that influences other borrowing costs in the economy, was forecast by 102 of 105 analysts surveyed by Bloomberg News.

The Fed gave a largely positive assessment of the U.S. economy, saying that expansion continued at a “moderate pace” and that a “range” of job-market indicators “confirms that underutilization of labor resources has diminished appreciably since early this year.”

The central bank also said that the risks to the outlook for economic activity and the labor market are now “balanced,” changing from a previous reference to being “nearly balanced.”

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Sustainable Improvement

“Americans should realize that the Fed’s decision today reflects our confidence in the U.S. economy,” Yellen said. “While things may be uneven across regions of the country and different industrial sectors, we see an economy that is on a path of sustainable improvement.”

Still, the recovery has been disappointing for many. Household incomes remain lower than they were a decade ago when adjusted for inflation, and wages have climbed only sluggishly even as firms hired back workers. Hourly earnings have risen by about an average 2.2 percent annual pace over the past seven years, compared with 3.3 percent in the 20 years through 2008.

The Fed said monetary policy is still “accommodative after this increase, thereby supporting further improvement in labor market conditions and a return to 2 percent inflation.”

The central bank acknowledged the state of low inflation, saying that it plans to “carefully monitor actual and expected progress toward” its 2 percent target.

As part of the decision, the Fed increased the interest it pays on overnight reverse repos to 0.25 percent from 0.05 percent to put a floor at the lower end of the range. It also raised the interest it pays on excess reserves held at the Fed to 0.5 percent from 0.25 percent to mark the upper end of the range.

In a related move, the Fed’s Board of Governors unanimously voted to raise the discount rate, which covers direct loans to banks, by a quarter point to 1 percent.

In addition to setting rock-bottom short-term interest rates during the crisis, the Fed engaged in three rounds of bond purchases aimed at suppressing long-term rates to stimulate borrowing and spending. Officials also provided unusually explicit guidance, assuring investors for years they intended to keep rates low well into the future.

Prior to 2008, the effective fed funds rate had never dropped below 0.63 percent, according to data compiled by the St. Louis Fed dating back to 1954.

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