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The Fed Hikes, Showing Confidence in U.S. Economy

| March 20, 2017

Equity markets at home and abroad rallied after the Federal Reserve raised its short-term interest rate target range on Wednesday and Fed Chair Janet Yellen expressed confidence in the U.S. economy. As was widely expected, the Federal Open Market Committee (FOMC) raised the federal funds target by a quarter point (0.25%) to a range from 0.75% to 1.00%. The central bank hiked rates for the first time this year, the second time in three months, and only the third time since the 2008–2009 global financial crisis. After announcing the quarter-point hike, Yellen indicated that the Fed would take a measured approach to further interest rate hikes. 

The Fed’s mission is sometimes complicated by the “dual mandate” of maximizing employment and moderating inflation. The unemployment rate dipped to 4.7% in February and inflation was close to the central bank's 2% target over the 12-month period. Yellen allowed that 2% is an inflation target and that it might rise above that level, just as it had been under it for the past few years.  Tellingly, Ms. Yellen emphasized, “It’s a target.”

Although the Fed’s current forecasting bias is clearly on the side of tighter monetary policy, its consensus on economic conditions remained muted, forecasting 4.5% unemployment and about 2% inflation for the coming three years. In that light, it bears repeating that one of President Donald Trump’s campaign promises was to get the economy to return to 3% growth. The economic and analyst community has its doubts about the attainability of 3 to 3.5% growth any time soon.

Fed fund futures rallied after the FOMC maintained its economic projections.  The futures market is now fully pricing in the next rate hike in September, an above-average probability of another rate increase in December, and three rate increases in 2018. The Fed tightening campaign will be constrained by the stubbornly sluggish nature of the U.S. recovery since the financial crisis almost ten years ago.

European markets had an eventful week, including the Dutch elections and another legal step to allow the UK to exit the European Union.  When all was said and done, the pan-European benchmark Stoxx 600, the blue chip FTSE 100, and other major indexes ended higher. Bank stocks were shaky early in the week as investors played defense in advance of the U.S. Federal Reserve meeting. But following the Fed’s rate hike announcement midweek, European banks, oil stocks, and mining stocks outperformed their U.S. peers.

Finally, Japanese stocks posted modest losses for the week. The widely watched Nikkei 225 Stock Average dipped 0.42% (83 points) and closed at 19.521.59. For the year-to-date, the Nikkei is up 2.1%, the broad-based TOPIX Index has gained 3.1%, and the TOPIX Small Index is up 5.5%. The yen strengthened for the week, closing at ¥113.1 per U.S. dollar, about 3.2% stronger than ¥117 per U.S. dollar at the end of 2016.

Although inflation accelerated for the first time in more than a year in January, the Bank of Japan kept its monetary policy unchanged on Wednesday. The policy board voted 7-2 in favor of keeping the interest rate on excess reserves held by the central bank for financial institutions at negative 0.1% and to continue to keep the yield on the 10-year Japanese government bond (JGB) anchored near 0.0%. To hold the 10-year JGB near zero, the central bank affirmed its commitment to buying long-term bonds at a pace of about ¥80 trillion per year (~$801 billion USD!). BoJ Governor Haruhiko Kuroda affirmed that the central bank would maintain the current QQE program until the “objective of price stability” was met, regardless of the 10-year U.S. Treasury rate. Anchoring the JGB at 0% should lead to further yen weakness versus the U.S. dollar over time.