Citing an improving economy and labor market, the Federal Reserve raised its key interest rate Wednesday for the first time in 2016 by a quarter percentage point, and projected slightly faster increases the next few years amid the prospect of a massive government stimulus.
In a statement after a two-day meeting the Fed said policymakers unanimously agreed to lift the benchmark federal funds rate – the rate banks charge each other for overnight loans -- from 0.4% to 0.6%.
Wednesday’s hike was just the second since 2006 despite an unemployment rate that has tumbled from 10% in 2009 to a near-normal 4.6%. The Fed has nursed along a sluggishly growing economy with near-zero rates since the recession ended seven years ago. Its latest move is expected to ripple through the economy, nudging up rates slightly for everything from mortgages and auto loans to corporate bonds and bank savings rates.
Fed policymakers are also forecasting three rate increases in 2017, up from two in September, and maintained their projection of three hikes each in 2018 and 2019, according to median estimates. They predict the fed funds rate will be 1.4% at the end of 2017, 2.1% at the end of 2018 and 2.9% at the end of 2019, up from forecasts of 1.1%, 1.9% and 2.6%, respectively, in September. Its long-run rate is expected to be 3%, up slightly from 2.9% previously.
Some economists believed the Fed would speed up its rate-hike timetable in the wake of Republican Donald Trump’s victory in the presidential race. Trump has proposed sharply cutting taxes, spending as much $1 trillion to upgrade the nation’s infrastructure and beefing up defense. All of those initiatives would spur economic activity and likely increase inflation as well as the national debt, possibly forcing the Fed to lift its benchmark rate more rapidly to head off excessive price increases. Rate increases theoretically curb consumer and business borrowing, damping economic activity.
A recent OPEC decision to cut oil production has pushed up crude prices and inflation expectations as well, and also could affect Fed moves next year.
But in recent weeks, Fed policymakers have said it was too early to factor Trump’s plan into their forecasts. It’s unclear, for example, how much a debt-wary Republican Congress might scale back his tax and spending plans. Aside from the election, however, the economy perked up in the third quarter, growing an estimated 3.2%, up from about 1% the previous nine months, partly because a long-standing pullback in business stockpiling appeared to bottom out.
Fed officials on Wednesday slightly upgraded their forecasts for the economy, and now expect growth of 1.9% this year and 2.1% in 2017, up from 1.8% in 2%, respectively. And with the unemployment rate at 4.6%, it lowered its estimate for the rate to 4.5% at the end of 2017 from 4.6% in September.
And with energy prices rising, the Fed slightly raised its estimate of overall inflation this year to 1.5% from 1.3% but it kept its estimate of 1.9% for next year, still a bit below its 2% target.
In its statement, the Fed painted a generally bright picture of the economy, saying “the labor market has continued to strengthen” and “economic activity has been expanding at a moderate pace since midyear.” It added that “job gains have been solid in recent months” and household spending has risen moderately but business investment has been “soft.”
More significantly, the Fed said market-based measures of inflation compensation, such as certain Treasury bond yields that account for inflation, “have moved up considerably but are still low.” That could herald faster price increases down the road.
Risks to its economic outlook “appear roughly balanced,” the Fed added, reiterating its upbeat assessment from September.
Despite Wednesday’s rate hike, the central bank’s monetary policy “remains accommodative, thereby supporting some further strengthening in labor market conditions and a return to 2% inflation,” the Fed’s statement said.
Meanwhile, markets already have been reacting to the specter of stronger inflation under a Trump administration. Yields on 10-year Treasury bonds have risen nearly a percentage point since September, pushing up 30-year mortgage rates to 4.13% from 3.47% over the past six weeks. And the dollar has strengthened as investors flock to U.S. assets, a rally that’s expected to hurt U.S. exports.
Both developments thus could curtail economic growth in the short term, though the recent stock market rally offsets much of the pain by making consumers feel wealthier and emboldening firms to increase spending.
Yet if long-term rates and the dollar remain frothy into next year while the economy is still subdued, the Fed could be forced to reverse course and raise rates more gradually to counteract those economic speed bumps.
When the Fed raised its key rate in late 2015 for the first time in nine years, policymakers forecast four additional bumps this year. A variety of forces stayed their hand, including China’s economic slowdown, volatile markets, the United Kingdom’s Brexit vote and weakness in U.S. economic and job growth.
But those headwinds largely have eased. U.S. economic growth picked up in the third quarter and monthly job gains have averaged a solid 180,000 this year. Although that’s down from 229,000 in 2015, economists say that’s a natural byproduct of a low unemployment rate that’s providing employers with a smaller pool of available workers.
For much of this year, the unemployment rate hovered near 5%, partly because discouraged workers on the sidelines streamed back into an improving labor market. That helped temper wage growth and inflation, and Fed Chair Janet Yellen said it gave the Fed more leeway to keep rates lower for longer to encourage the return of some Americans to the labor force.
But the labor force has shrunk the past two months, and the unemployment rate fell from 4.8% to 4.6%, raising the prospect of faster pay growth. Average earnings gains hit a seven-year high in October. And a core measure of annual inflation that strips out volatile food and energy costs has edged up to 1.7%, closer to the Fed’s 2% target.