Washington, D. C., USA: The Federal Open Market Committee, (FOMC), of the Federal Reserve Board on Wednesday announced a quarter-point increase in interest rates – 1.50 – 1.75 % – as the policy making committee wound up its first two-day meeting under new Fed Chairman Jerome Powell. The Fed Dot Plot is anticipating two more hikes in 2018.
“The Committee expects that economic conditions will evolve in a manner that will warrant further gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run” the FOMC said.
A March rate hike had been widely expected as unemployment nears record lows and economic growth is expected to pick up in 2018. Powell inherited an economy in decent shape but he will have to normalise rates while keeping growth on track. Powell told Congress recently that, in his personal view, the economy has strengthened since December, when Fed officials last updated their forecasts for the economy.
The expectation was for 0.25% increase to a target range of 1.5 percent to 1.75 percent and for the Feds to boost their growth outlook for 2018 and 2019, while lowering their forecast for the unemployment rate.
The FOMC likes to lead markets not follow them. The stars were aligned for a further policy tightening this week following data showing inflation is on the rise, so not much of a surprise here. With a 4.1 percent unemployment rate, the U.S. is within range of what the Fed considers the ideal job market a stable economy. Economists were wondering whether faster economic growth might cause the Fed to pick up the pace of its rate hikes. The Fed had signaled three rate increases for 2018, but accelerated growth could cause policymakers to add an additional hike. When FOMC later announced that they anticipated the rate of economic growth would exceed their expectations in 2018 of its sustainable longer-run pace, it was seen as an upward revision of it’s forecasts and a 4 rates hikes acme into play
The February employment report released showed U.S. economy added 313,000 jobs in that month, the fastest pace of growth since summer of 2016. The unemployment rate was 4.1 percent for the fifth straight month, the lowest level since December 2000. February jobs far exceeded projections, and the month was the best for labor growth since July 2016.
Fed officials were also likely to boost their growth projections because of stimulus added to the economy since their December meeting. That includes a large tax cut that will boost profits for businesses and put money in consumers’ pockets. It also includes an additional $300 billion in government spending over the next two years, the result of a budget agreement approved by Congress in February.
The Fed has raised the benchmark federal funds rate five times in quarter-point steps since December 2015. Prior to that, the central bank held rates near zero for seven years to encourage borrowing and spending and help support the recovery from the Great Recession.
Increases in the federal funds rate eventually move borrowing rates for consumers and businesses higher.
The Federal Open Market Committee meeting
The Federal Reserve Act of 1913 charged the Federal Reserve with setting monetary policy to influence the availability and cost of money and credit.
The Federal Open Market Committee (FOMC) meeting is a regular session held by the members of the Federal Open Market Committee, a branch of the Federal Reserve that decides on the monetary policy of the United States.
During these meetings, the FOMC reviews economic and financial conditions and determines the federal funds target rate
A decline in the target rate could stimulate economic growth; however, too much economic activity can cause inflation pressures to build. A rise in the rate limits economic growth and helps control inflation pressures; however, too great an increase can stall economic growth. The FOMC seeks a target rate that will achieve the maximum rate of economic growth.
A change in the federal funds rate can affect other short-term interest rates, longer-term interest rates, foreign exchange rates, stock prices, bond prices, the amount of money and credit in the economy, employment and the prices of goods and services.
So traders and investors around the world usually attempt to predict where monetary policy is headed next in each Fed meeting, and adjust their strategies and portfolios accordingly.
The Federal Funds Target Interest Rate
The federal funds rate is the interest rate that banks charge each other for overnight loans, meaning that it effectively acts as the base interest rate for the US economy. Changes to the federal funds rate will impact short and long-term interest rates, forex rates, and eventually economic factors like unemployment or inflation. This, in turn, will play out across the global economy.
While it doesn’t have a direct say over the rates charged by banks to lend money to each other, the FOMC can indirectly change the fed funds rate using three policy tools that affect money supply. These are open market operations, the discount rate, and reserve requirements.
Open market operations are the buying and selling of government bonds on the open market.
When the FOMC wants to decrease monetary supply it will sell bonds, taking money out of the economy and in turn raising interest rates. When it wants to increase money supply, it will buy bonds, injecting money into the economy and lowering rates.
As well as borrowing this money from each other at the federal funds rate, banks can borrow money directly from the Federal Reserve itself.
The interest rate a bank will have to pay to borrow from the Fed is called the discount rate. A lower discount rate will encourage a lower federal funds rate, and vice versa.
Reserve requirements are the percentage of a bank’s deposits from customers that it has to hold in order to cover withdrawals.
If reserve requirements are raised, then banks can loan less money and will ask for higher interest rates. If they are lowered, then the opposite happens.
Quantitative easing (QE) is an extra measure that the Fed can apply in times of severe financial situation. It is usually only used once the above policy tools have been exhausted.
In function, QE looks fairly similar to open market operations. The FOMC buys securities on the open market, injecting money directly into the system.