Federal Reserve: Beyond The Rate Hike

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by: Jeremy LaKosh

Summary

The Fed hiked the Fed Funds rate to 1-1.25% on Wednesday.

FOMC economic projections hint at lower inflation and higher growth.

The long-term Fed Funds rate target takes on a new meaning.

The highlight of the Federal Reserve's meeting on Wednesday was the 25-basis point increase in the Fed Funds rate to 1-1.25%. Despite the increases in the Fed Funds rate throughout 2017, long-term Treasury yields are lower than they were six months ago. In addition to this, borrowers requested a mere $30 million from the discount window in May. This represented consistent declines and a far cry from the $400 billion borrowed in October 2008.

An area that may be considered more important than Fed Funds is the FOMC economic projections. While static numbers are good indicators of the future, I like to compare the Fed's economic projections with its previous meetings. The trends in the data tend to speak louder than any one point in time.

One of the most boring (or stable) trends for the Federal Reserve has been inflation. While sticking to its 2% inflation projection for 2018, 2019, and beyond, the Fed lowered its 2017 projection to 1.7%. While the Fed does not describe causes, the tame May CPI report likely weighed on the revision. For investors, equity markets likely see increased volatility when inflation comes under pressure. This does raise the importance of this summer's monthly inflation reports and the next Fed projections.

In one of the more dramatic trend accelerations in projected data, the Fed drastically lowered its unemployment expectations. The changes were 0.2% for 2017 (4.3%), 0.3% for 2018 and 2019 (4.2%), and 0.1% for the long-term target (4.6%). The long-term target is a far cry from 5.5% in late 2013. The Fed has stated on several occasions that full employment is a key factor to future Fed Funds rate hikes. Therefore, as long as future monthly employment reports meet or exceed these expectations, Fed Fund hikes will continue.

Another surprise was the upward revision in GDP for 2017 from 2.1% to 2.2%. This represented the second estimate increase in the last three projections. What's surprising is that this upward revision occurred in the face of a weak 1.2% first-quarter growth estimate. The Fed seems consistent in its belief that growth is going to drop slightly in 2018 and afterwards. This is likely due to the increasing demographic growth of retirees in the United States.

The Fed Funds forecast can give Fed watchers an idea of how many times the Fed expects to raise interest rates in the future. Based on the most recent survey, the Fed expects to raise rates one more time IN 2017, three times in 2018, and three or four times in 2019. The moves should bring the Fed Funds rate close to its long-term target by the end of 2019.

While I have been following the trend of the long-term Fed Funds rate for over 5 years, the meaning of the data became extremely important this week. The Fed, in adjusting its plans to policy normalization, stated that the size of its balance sheet would decline in the event Federal Funds normalization were achieved. In my opinion, this means that once the Fed Funds rate reaches the long-term target, the balance sheet will begin to decline.

The long-term Fed Funds target has been at or near 3% for four consecutive projections. This is a far cry from the 4.2% target in January 2012. While on track to achieve this target by late 2019 or early 2020, one question that remains is whether the Fed will increase its long-term Fed Funds target in future meetings. If the target is increased, will that delay the reduction in the Fed's balance sheet holdings?

Only time will tell.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.