Fed Reserve: Why rates are increasing

The Federal Reserve this week finally did what they have not done since last December, increasing the federal funds rate to ½ to ¾%. This increases very short term interest rates by .25%.

The Fed Reserve action trails the actual rise in interest rates which has occurred since the Presidential election.

The trend in interest rates since December, 2014 is as follows:
  • Most interest rates rose during 2015, both long and short term.
  • During 2016, short and longer term interest rates were expected to rise, but actually declined significantly from January, 2016 through the fall, 2016.
  • After the election, short and long term interest rates have increased significantly, especially in relative terms.

Irrespective of the Federal Reserve, the financial markets moved interest rates higher based on increased future expected economic growth and Federal spending as a result of the election.

See the following chart for how interest rates have moved over the past two years:

table-a

The Federal Reserve can heavily impact very short term interest rates. The financial bond markets, and really their expectations of future economic activity, controls the future of mid-longer term interest rates.

While it is important to understand the thoughts and forecasts of the Federal Reserve, you should realize that financial markets control much of the interest rates that really matter, such as the corporate debt, mortgage rates and longer term US Treasury debt.

The Federal Reserve provides economic and monetary projections quarterly. While these projections have generally been inaccurate during the past few years, they are still important to consider.

The following are the projected federal funds rate data from the forecasts of December, 2015, September, 2016 and December, 2016. You should note that while the forecasts for short term interest rates have increased from September to December 2016, those forecasts are still much lower than as forecasted 12 months ago.

table-b

The major change from the September, 2016 to December, 2016 median forecast for 2017 is raising rate hike expectations from two .25% increases to three .25 increases.

Conclusion: Less emphasis will be placed on the Fed in the next year. Expectations of policy changes have caused interest rate increases since the election. As policy and legislation are enacted and implemented by the new administration, their impact on the economy will have much greater influence on the movement of interest rates.

If the economy grows faster than expected, employment continues to be strong or stronger and if inflation becomes greater than 2% annually, for whatever the reason, then interest rates will likely rise greater than the Fed’s forecasts.

 

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