This afternoon, the Federal Reserve (Fed) announced its intention to raise interest rates another 0.25%, representing (merely) the third rate hike in almost a decade. So what does this decision mean for the broader economy and for client portfolios? For all intents and purposes, today’s interest rate hike was expected and supported by underlying fundamentals. Markets should continue to react positively as we see the transition from monetary policy to fiscal policy.
As we first described in 2011, the Fed has moved from its traditional referee role to serving as both a referee and a player in capital markets. By suppressing interest rates at rock-bottom levels for an extended period, it artificially lowered risks to drive bond and stock prices higher ahead of what fundamentals typically suggest—all in an effort to induce spending and investment to drive growth.
The experimental measures it deployed, such as “quantitative easing,” “forward guidance,” and “negative interest rates” became conversational fodder as opposed to concepts only found in arcane textbooks. “Fed watching” has become a mainstream sport, with every Fed communication resembling a carefully crafted “take-home test” for investors. Over time, the Fed has effectively moved from leading capital markets to being led by them, driven by the fear that capital markets would collapse if ever the Fed failed to meet market expectations. Simply put, the Fed has essentially been the only game in town.
Recently, however, as described in our 2017 Capital Markets Forecast, this paradigm finally began to shift last fall when economic growth showed signs of broadening and picking up pace. Inflation readings started to trend more decisively towards the Fed’s stated target of 2%. Concurrently, job growth momentum continued, driving the unemployment rate lower.
Since the November presidential election, capital markets have begun to take their cue from Washington with the hope that a single-party government will deliver on campaign promises of tax cuts, government spending on infrastructure, and deregulation. Investors have begun to focus on how fiscal policy and structural reform may be able to improve corporate earnings. Additionally, stock markets have appreciated as underlying fundamentals have improved, offsetting the rise in interest rates that have occurred since then.
Today, these improvements in fundamentals allow the Fed to take another step towards normalization. The U.S. dollar has also begun to stabilize as the European Central Bank and Bank of Japan no longer move so quickly in the opposite direction of the Fed. This, in turn, has put less pressure on economies in the emerging world, a concern previously cited by the Fed as a reason for not raising interest rates.
As the Fed affirmed today, it expects to increase the pace of normalization through 2017 and into 2018. The ensuing conversation should include plans to shrink the $4 trillion balance sheet of securities the Fed built up over the past eight years, at which point it will be able remove itself from the game, if you will, and instead resume the role of referee.
However, there is still one wildcard left which merits close attention—Janet Yellen’s term as chair of the Federal Reserve is set to expire in January 2018. The new administration has the opportunity to either extended her term or appoint a successor. If there is one thing capital markets prize above all else, it is the independence of the Federal Reserve. Any sign of partisanship to advance a political agenda may quickly upset capital markets even as monetary policy continues to normalize.
Although capital markets have been laser-focused on the movements of the Fed, March signaled another historic milestone. This month, the U.S. GDP expansion that began in early 2009 became the third-longest period of economic growth; only the 1960s and 1990s expansions were longer. Perhaps nothing speaks more clearly about how unusual the last few years have been than the juxtaposition of an expansive economic cycle and a nascent interest rate cycle.
We will continue to watch the actions of the Federal Reserve and keep clients apprised of how it may impact their portfolios.
 Source: National Bureau of Economic Research since NBER began its research in the mid-1800s. Economic growth defined as not having two consecutive quarters of negative GDP growth.