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December 16, 2015- As you’re probably aware, the Fed decided to raise their benchmark lending rate by 0.25% from a 0% to 0.25-0.50% range.  They also communicated a ‘gradual’ path for subsequent rate hikes at a pace much slower than what they’ve communicated in the past.  For 2016, the Fed expects to raise rates four times.  If current trends hold and core inflation returns to 2% (which they don’t expect to do so until 2018), then the Fed is projecting the benchmark lending rate to rise to 1.375% in 2016, 2.375% in 2017, and 3.25% at the end of three years.  In contrast, the Fed raised rates 17 times in succession over the 2004-06 period.  In addition, only four voting members see Fed funds above 3% by 2017, as opposed to seven in September.

At her post-meeting press conference, Fed chair Janet Yellen reiterated the committee’s decision as a “vote of confidence” in the U.S. economy despite the fact the current expansion is somewhat long in the tooth.  Today’s decision and post-FOMC remarks are largely consistent with what I wrote about last week (‘Mission Accomplished’). 

Here is a breakdown of the Fed decision:

WSJ: Fed Raises Rates After Seven Years at Zero, Expects ‘Gradual’ Tightening Path

Keep in mind that even a gradual path of rate hikes is facing several headwinds that would normally keep the Fed on pause or contemplating easier, rather than tightening, policies.  I spell these out in ‘Mission Accomplished’:

  • Possible earnings and revenue recession (3Q2015 S&P earnings declined 1.3% and revenues declined 3.9%);
  • Declining operating margins;
  • An inventory build-up that will serve as a drag on near-term economic output;
  • A continuing slowdown in China (latest trade report reveals a significant slowdown in exports and imports); and
  • A possible slowdown in consumer spending (some early indicators such as department store commentary, retail traffic, and credit card transactions point to less-than-robust holiday shopping season).

On the other side, the Fed will find itself having to play catch up if inflation accelerates beyond their long-term projections.  This is an unlikely scenario but one that economists are closely tracking, particularly wage pressures. 

U.S. stocks are rallying post the decision with the S&P up 1.22% as of this writing. ETFs that track high yield are also rallying. There is a bit of a sell-off in bonds with the Barclays Aggregated Index down a marginal amount. EUR/USD has not moved that much with remains at 1.09 down from 1.10 last week. 

Basically, the FOMC didn’t rock the boat with their decision (unlike September), but the follow-through will be key. 

Investor Talking Points:

  • As expected, the Federal Reserve raised their key benchmark lending rate by 0.25% to 0.25%-0.50% range from 0% which was set as part of an emergency monetary policy response to the 2008 global financial crisis.
  • The Fed expects to adopt a ‘gradual’ path of rate hikes culminating in a rate target of 1.375% at the end of 2016, 2.375% at the end of 2017, and 3.25% at the end of three years.  This path assumes that employment and inflation trends meet the Fed’s forecasts. 
  • The Fed does not expect core inflation to return to 2% until 2018.
  • The Fed faces multiple near-term headwinds including 1) an extended business cycle that has recovered from the ’08 financial crisis but has produced low nominal growth; 2) year-over-year declines in S&P 500 operating earnings and revenue; 3) decline in S&P operating margins; 4) global slowdown particularly in China; 5) deteriorating industrial sentiment; and 6) signs of a slowdown in consumer spending and employment gains.
  • On the other side, the Fed will find itself having to play catch up if inflation accelerates beyond their long-term projections.  This is an unlikely scenario but one that economists are closely tracking particularly, wage pressures. 
  • The U.S. equity market initially rallied following the Fed decision as the decision and post-meeting comments were largely consistent with market expectations that included a final exit from the emergency policies set in place back in 2008 and a rate hike path that will be much more gradual than prior rate hike periods. 
  • U.S. bonds did not react much to the decision although high yield bonds are performing well.  Keep in mind that the 10-year Treasury yield currently yields 2.27% which represents a theoretical ceiling on how high the Fed should raise rates.  Longer-term bond yields would need to eventually rise to meet the Fed’s forecasts, so it will be interesting to see if the Fed’s outlook will eventually drive yields higher.