It has been exactly seven years (to the day) of zero interest rate policy in the US.
After months (maybe years!) of pontificating as to when the Federal Reserve would move, they have finally delivered a 25 bp increase in rates. This time around, the Fed is implementing a new method of tightening due to structural changes in markets since the 2004-2006 tightening cycle. They will be setting a range as to where the Federal Funds rate should sit by moving the reverse repo rate to 25bp and interest on excess reserves to 50bp (from 5bp and 25bp respectively). The latter two markets did not exist in prior tightening cycles. The Fed also announced that they will maintain their $4.5tn balance sheet by continuing to reinvest maturities until normalization is well under way. The decision was unanimous amongst FOMC participants.
The market reaction following the announcement was relatively muted. US 2-year Treasury yields rose 4bps throughout the course of the day to 1.00% while 10-year yields moved a similar magnitude towards 2.30%. Risk assets fared well as the rate hike was tempered by a somewhat dovish view of the tightening cycle; credit spreads have tightened on the day while equity markets have continued to rally. The dollar reaction, despite concerns amongst many market participants, was also benign.
Markets had largely expected this move as the implied probability (derived using Fed Funds futures) of a December rate hike had risen from 25% to roughly 80% over the last three months. The conversation over recent weeks has been largely about the pace of the hiking cycle. Chair Yellen assuaged fears of a rapid pace of hikes by stressing that further hikes will be both gradual and data dependent. However, it is worth noting that the Fed still foresees four 25bp rate hikes in 2016, while the market is pricing in only two. Four hikes over the course of a year would be a historically slow pace compared to the previous cycles. To put this in perspective, during the 2004-2006 rate hiking cycle, the Fed hiked eight times in the first year of lift-off. Of course, we know that “this time is different” and that there are various reasons why potential growth has shifted structurally lower, and therefore requires a lower neutral Funds rate. However, we believe this gradual pace will be increasingly called into question over the next several months. The performance of risk assets, the dollar and the global backdrop will be key in determining the future of Fed policy.