They did it! After almost 10 years, Federal Reserve officials raised interest rates -- up 25 basis points from zero.
The move was telegraphed in advance and there was consensus that the Fed wouldn't wait any longer. The "forward guidance" provided by the Fed actually boxed the bank into a corner -- if the federal funds rate stayed at zero through 2016, it could have hurt the regulator's credibility and left the market with a heavy feeling going into the new year. The markets focus would have quickly shifted to what does the Fed know that we don't. The Fed did what it had to do: It raised the interest rate and issued a dovish commentary. Since monetary policy works with a lag; the FED was concerned about the chances of the economy overheating necessitating sharper rate hikes later and an economic downturn leaving poor policy tools in its arsenal.
The 25bps increase is really more symbolic than important. Inflation is running below 2% and there is no evidence of economic acceleration. The U6 measure of unemployment still hovers around 10%. The labor participation rate still sits at 62%, a near-40-year low. Inflation expectations will probably decline if measures such as the prices of commodities, oil, copper or iron ore are used.
The only thing that is clear is that it will be years before we have any idea if the bank knows where the economy is headed and what the Fed just did was correct.
So, where do things go from here?
Credit spreads are widening; the dollar has strengthened; and the S&P 500 has slightly declined for the year and this shot across the bow of the frothiness of the market may result in financial instability. The 2% inflation target may be too low in a world of wage rigidity and zero interest rates and professional forecasters expect inflation to be less than 2% for more than a decade. There is a need to focus on inflation expectations; and how dollar strength will affect corporate earnings. With the European Central Bank and other central banks easing and a Fed tightening this will cause the dollar to continue to gain strength against the Euro and other currencies. This will pressure companies that sell outside the borders of the U.S. A strengthening dollar will also continue to put downward pressure on already-weakened commodities.
It would be nice to think that we reached a finish line with this interest rate hike. What will be remembered is the effective manner in which the Fed guided expectations toward a rate increase. The Fed should use its new found credibility to signal that it will not raise rates too quickly, heighten its awareness of financial instability and will take note of problems in emerging markets. This marathon is just beginning.
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