A cloud of uncertainty was lifted from the financial markets last week after the Federal Reserve raised interest rates for the first time in nearly a decade, although a muted outlook for inflation and commodity prices kept policymakers cautious about future policy.
The Fed raised its target for the federal funds rate by 25 basis points to 0.25%-0.5%, as expected, following seven years of near-zero rates. While the decision for liftoff was unanimous, the Fed cautioned that its rate tightening timetable would be “gradual.”
“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate,” the Fed said in its official rate statement.
As a result, “the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.”
The median 2016 target for the federal funds rate remained at 1.375%, unchanged from September, according to new economic projections released alongside the official policy statement. This implies there will be four 25-basis point increases to the federal funds rate next year. According to a recent poll conducted by Reuters, two-thirds of economists expect the second rate hike to occur in March.
While the initial response from Wall Street was positive, the Fed-induced rally quickly faded, as investors continued to monitor volatile commodity prices. The price of oil plunged to seven-year lows last week, pressuring energy stocks and the broader financial market. Gold prices also crashed to six-year lows one day after the Fed announcement thanks to a surging US dollar.
Although the reaction to the historic Fed statement didn’t play out as many had expected, higher interest rates will play a major role in the global financial system moving forward. The already bullish US dollar is expected to strengthen even further at the expense of non-yielding assets, such as gold. A firmer dollar is also crushing profits at leading US multinationals, a trend that is expected to continue next year. The dollar’s strength was partly responsible for the first back-to-back decline in Wall Street quarterly earnings in six years.
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