We have lift-off, but can the Fed normalise?

Fed hikes rates

It has probably been the most long awaited quarter of a point rate rise in history, but the US Federal Reserve (Fed) has finally pulled the trigger by increasing the target range for the Fed funds rate by 25 basis points (bps), to 25-50bps.

In the accompanying statement the US central bank noted the further improvement in the labour market and that “underutilisation of labour resources has diminished appreciably”.

Although inflation has yet to return to target, it was expected to rise to 2% as the transitory effects of declines in energy and import prices dissipate.

Taking into account domestic and international factors, they said the “risks to the outlook are balanced”.

The immediate move has been well telegraphed and so should not come as a surprise to markets; the question now is where are interest rates headed?

The statement said future moves would be data dependent and that “economic conditions will only warrant gradual increases in the Fed funds rate”.

This is consistent with past statements, but puts the spotlight on the Fed’s updated forecasts which accompanied the statement.

These were little changed and show an economy growing at 2.4% next year with unemployment falling further to 4.7% and inflation ending the year at 1.6%.

Policy path

The inflation projection is a tad lower than before and no doubt reflects the move in the dollar and oil prices since September.

The projected policy path is also a little lower with the median Fed funds rate at 1.4% by the end of next year and 2.4% by the end of 2017.

The long run rate is still at 3.5% though, indicating a slow lift-off and then greater tightening further out.

Although these interest rate projections are not meant to be guidance they are read closely by the markets and in this respect were probably a bit less dovish than might have been expected.

There is plenty of evidence (some of which was presented to the Fed back in October) that the long run equilibrium rate in the US should be 2% (zero in real terms) or thereabouts, so they could have cut their long run forecast.

The Fed and Chair Janet Yellen remain committed to a gradual tightening, but the danger is that if they are perceived as being more hawkish than the very low expectations built into markets, then the US dollar will strengthen and push down inflation further.

In this way the normalisation of interest rates could stall as the currency markets tighten policy for the Fed.