Fed hikes key interest rate and readies plan to reduce assets in validation of economic recovery

June 14, 2017 3:05 PM PT

Reporting from Washington — Federal Reserve policymakers on Wednesday enacted their third small hike in a key interest rate in six months, and they signaled another rate increase to come by the end of the year.

The latest move was widely expected by investors and reflected the central bank’s confidence that the labor market and the broader economy were continuing to make progress. Fed officials are convinced the economic slowdown over the winter was temporary.

The 0.25-percentage point increase in the federal funds rate means consumers will soon pay that much more in interest for balances on their credit cards and some other loans.

Fed officials also announced that they intend this year to begin reducing the $4.5 trillion in Treasury and mortgage securities and other assets the central bank currently holds, mostly from extraordinary purchases made since 2008 in an attempt to stimulate the economy. Fed officials believe these asset purchases helped lower mortgage rates and spur investment activity and economic growth. Shedding these bonds could also push up borrowing costs, and thus presents some risks.

Fed Chairwoman Janet L. Yellen, in a quarterly news conference Wednesday after the release of the policy statement, said she and her colleagues “continue to expect that the ongoing strength of the economy will warrant gradual increases in the federal funds rate” to sustain a healthy labor market and price stability.

But some economists argued that the Fed should slow its rate-hike plans, given indications of an easing of inflation over the past three months. Inflation has consistently fallen below the Fed’s 2% target since 2012, but had been moving upward close to that level prior to spring.

With inflation now having slipped further below the Fed’s target and wage growth remaining weak, analysts say the bank has more latitude to hold rates steady. “The Fed should feel less need to raise rates,” said Dean Baker, co-director of the Center for Economic and Policy Research in Washington, D.C.

One Fed policymaker, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, apparently agreed as he voted against a rate increase. He was the lone dissenter on a voting committee of nine.

Yellen downplayed the recent decline in inflation, attributing it to some temporary “idiosyncratic factors,” particularly a large decline in wireless service plan prices and a drop in prescription drug costs. While Fed officials expect inflation to remain lower than they prefer in the short term, Yellen said continued improvement in the labor market means “the conditions are in place for inflation to move up.”

Supporting that view, members of the policymaking Federal Open Market Committee indicated that they expected one more 0.25-percentage point increase this year and three next year — the same as they had forecast in March.

The Fed’s benchmark short-term rate, which influences consumer and business lending, will now rise to between 1% and 1.25%. Fed officials expect to lift that rate gradually until it reaches 3% by the end of 2019.

Brian Bethune, chief economist at Alpha Economic Foresights, said the Fed’s moves show “they’re very confident about the performance of the economy.”

“It’s not robust growth, but at this point, things are going fairly well and there’s accumulating evidence that now the global economy is finally starting to improve,” he said.

Although job gains have moderated in recent months, they still have been solid, more than enough to absorb the natural growth of the workforce population.

Overall, Fed officials slightly raised their expectations for economic growth this year, to 2.2% from the 2.1% projected in March. The forecast for 2018 remained the same, at 2.1%. The Trump administration has said that with the right policies, such as tax cuts and infrastructure spending, it could boost economic growth to 3% or higher.

Although Trump’s fiscal stimulus plans look less likely to pass Congress this year than previously anticipated, Yellen said she didn’t think that would change the near-term economic outlook.

“Although many forecasters have pushed back somewhat on the timing of expected policy changes, such as changes to tax policy or fiscal policy more generally,” Yellen said, “I would say that, based on my observation of actual spending behavior and my discussions with our wide range of contacts, I haven’t seen very much evidence that ... expectations of policy changes have driven substantial changes in either consumer spending or investment spending.

“So I really wouldn’t expect any significant pullback,” she added. “Many of our business contacts, I think, their confidence remains high. They have not really changed their plans yet, and they have a wait-and-see attitude.”

Fed officials were more optimistic about unemployment. They now expect the rate to be at 4.3% by the end of the year, down from a March forecast of 4.5%.

The Labor Department reported the rate fell to 4.3% in May, the lowest since 2001. Fed officials expect the rate to decline to 4.2% next year.

But they downgraded their expectation for inflation to 1.6% this year, down from 1.9% in March. The Fed’s annual target is 2%, which policymakers still anticipate will be reached next year.

Investors have been eagerly expecting details of how the Fed would reduce the assets on its balance sheet. The value of assets soared from about $925 billion before the financial crisis hit as the Fed started to buy securities to try to stimulate the economy.

The plan announced Wednesday calls for the Fed to reduce its holdings by gradually allowing an increasing amount of maturing securities to be run off each month, until it reached $50 billion a month.

Over time, the Fed’s assets would be reduced “to a level appreciably below that seen in recent years” but larger than before the crisis, officials said.

Yellen said the plan would lead to “a gradual and largely predictable decline” in the assets. The reductions would begin this year “provided that the economy evolves broadly” as Fed officials are forecasting, she said.

Policymakers said they would be prepared to stop the reductions if there were “a material deterioration in the economic outlook” that led to “a sizable reduction” in the federal funds rate.

The amount of the monthly withdrawals was a little more than markets had expected. Chris Rupkey, chief financial economist at Mitsubishi UFG Union Bank in New York, said it was unclear what this reduction in liquidity would mean for interest rates.

“If the Fed brings the balance sheet down too quickly it could pull the rug out from under markets and send yields soaring especially for the mortgage-backed securities market,” he wrote in a note to clients. “If they get it wrong, they could have millions of homebuyers breathing down their necks. It’s hard enough to get a mortgage as it is.”

During the news conference Wednesday, Yellen was asked about her own future as Fed chair. She would not comment beyond her intention to serve out her term, which ends next February. President Trump has sent mixed messages over the past year about Yellen.

“I have not had conversations with the president about future plans,” she said.

Of the three vacancies on the seven-member Fed board of governors, Yellen said, the White House is “working hard” to identify nominees. “I do very much hope that there will be nominations in the not-too-distant future .... I look forward to having a full board,” she told reporters.

Twitter: @JimPuzzanghera

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UPDATES:

3:05 p.m.: This article was updated with additional analysis and reaction.

11:55 a.m.: This article was updated with comments by Federal Reserve Chairwoman Janet L. Yellen.

This article originally was published at 11:05 a.m.