Insights Into The Federal Reserve’s Decision to Begin Raising Interest Rates

The Federal Reserve announced that it is beginning the process to raise interest rates.

The summary points are this:

1) Raised the target range for Federal Funds by .25% to .25%-.50%. Fed Funds are what financial institutions use to borrow between themselves.

2) Raised the Discount Rate by .25% to 1.00%. The Discount Rate is the rate the Federal Reserve charges banks if they need to borrow from the Federal Reserve for temporary liquidity purposes.

3) Communicated that the decision to raise rates by .25% signaled their confidence in the economy.

4) Communicated that future rate increases would be gradual and dependent on economic conditions related to employment and inflation as well as readings on financial market conditions and international developments.

5) Most financial institutions followed suit by raising the Prime Lending Rate by .25% to 3.50%

Their is plenty of media coverage over this decision and what various analysts or commentators think of the decision. Brian Brill, our Senior Portfolio Manager for Fixed Income provided some information and insight that you may not hear from the headline media stories. Here is Brian’s commentary.

 

The Federal Open Market Committee (FOMC) voted 10 – 0 to raise the target Federal Funds rate to 0.25% to 0.50% from 0.0% – 0.25%. As was noted in last Friday’s “Week in Review”, the Fed has not voted to increase the Fed Funds rate in the last nine and a half years (June 2006) and it has been eleven and a half years since it last began a hiking cycle (June 2004). The Fed also voted to increase the Discount rate 25 basis points to 1.00%. These actions were highly anticipated and therefore market reaction has been somewhat muted. Early market reaction, based on where yields were before the announcement, has interest rates increasing 2 basis points in the short end (2 year maturity) while the long end (30 year maturity) has decreased 2.5 basis points. The long end is outperforming with the yield curve flattening.

In its statement they noted: “The committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.” They also said, “The committee judges that there has been considerable improvement in labor market conditions this year, and it is reasonably confident that inflation will rise, over the medium term, to its 2 percent objective.”

The Fed also released its Summary of Economic Projections (SEP) and a newly revised forecast for the Federal Funds rate (Dot Plot forecast) . The SEP sees the economy expanding next year a little more than what they expected in September while maintaining the same expectations for growth in 2017 and 2018 that existed in September. The upper bound of the longer term expectation for economic growth decreased from 2.7% to 2.8%. Unemployment expectations decreased for next year and remained steady thereafter. Inflation expectations decreased for next year but then start increasing to a target of 2.0% in 2018.

The Dot Plot indicates that the members did not change their expectations for year end 2015 (.375%) or 2016 (1.375%) but lowered year end numbers for 2017 (2.375% from 2.625%) and 2018 (3.25% from 3.375%). This may be taken as dovish since they have decreased expectations and the path to higher rates may be more gradual. The market continues to believe that the path to future rate increases is lower and less sloped than what Fed Officials predict. The pattern we have seen over the past few years is that the Fed is gradually lowering their forecasts and growing closer to the market forecasts.

In the near term, the markets will be monitoring several key market rates for signs of near term success in the Federal Reserve’s strategy.

First will be the overnight London interbank offered rate fixing (Libor). The rate is based on what banks think it would cost them to borrow dollar deposits in London. One-week Libor rates began rising last week in anticipation of the hike, which would take effect the day after the decision. On Tuesday, it was 0.33%, up from 0.18% on December 9^th. The market has already priced in a lot of the move even before the hike.

The New York Fed will be keenly watching rates on repurchase agreements, known as repos. In an overnight repo, borrowers take cash from counterparties and post securities as collateral, and then unwind the trade the next day. The Fed uses reverse repos (i.e. the Federal Reserve takes cash from market participants, gives them collateral and pays them an interest rate) to temporarily drain liquidity from the financial system.

Rates on commercial paper, which companies use to finance short-term borrowings, will also be monitored. The Fed’s goal is to raise rates charged not just to banks, but the entire spectrum of borrowers in the U.S.

Today (Thursday) will be significant. This will be the results of the Fed’s first overnight reverse repo operation after the rate hike. The Fed has been testing the overnight reverse repo facility, a key part of its toolkit, for more than two years, mostly at a 0.05% rate. This program, which allows the Fed to tie up the nearly $3 trillion of excess cash created from its bond purchases, is expected to offer a 0.25% rate on overnight borrowings after the hike. This is to form the bottom of the Fed’s new target range.

The big question for the Fed is how much money investors will offer to lend to it at this rate, and whether it’s more than the limit set by the central bank. If investors offer to lend the Fed more money than the Fed is willing to borrow, the central bank won’t be able to keep interest rates in its new target range. Over the last 2 years, it’s been testing the facility with a cap on transactions of $300 billion per day. That does not mean this will be the cap for the actual transactions. The Fed holds over $4.5 trillion in securities; much of which can be used as collateral.

Depending on where the Fed sets the cap, the rest of the nearly $3 trillion of cash the Fed created to buy bonds that isn’t lent back to it through reverse repos is deposited in accounts at banks, which take the money and keep it on deposit at the central bank in the form of excess reserves. The Fed now will pay banks 0.50% interest on excess reserves. This will form the top of its new target range.

The finale will come Friday morning when the first post-liftoff Federal Funds effective rate print is published. The effective rate is based on trades the previous day and is the main rate the Fed targets. If the reverse repo operation on Thursday afternoon isn’t oversubscribed, the Fed Funds rate should trade above the 0.25% floor established by the rate the Fed offers to borrow at through reverse repos and officials can declare a successful start to liftoff.

Brian Brill, CFA

Vice President

Senior Portfolio Manager-Fixed Income

Washington Trust Bank

 

 

---