The Federal Reserve announced a much-expected interest rate hike last Wednesday, the third increase since December 2015, and added 25 basis points to the Fed’s key rate. The new target range is now from 0.75 percent to 1 percent, with two more rate hikes almost certainly coming by the end of 2016. These developments are in harmony with the Summary of Economic Projections (SEP) which suggests a total of three hikes this year, followed by another three next year.
This means the Fed believes that economic growth is picking up, and is more concerned about inflation. They are raising rates towards historically average levels, which exceeded 5 percent for most of the past few decades. Although the next few increases could push the key rate towards half the level of the historical average, it is evident that the Fed is returning to a traditional monetary policy after years of near-zero interest rates. The following chart shows the Fed funds rate since 2007.
The latest U.S. job report published last Friday showed the United States generated 235,000 new non-farm jobs in February, beating the expectations of 190,000 by Wall Street. With the unemployment rate at 4.7%, and inflation reaching the Fed’s target of 2%, it was almost certain a rate hike was on its way.
But not all were convinced by this data. The Minneapolis Federal Reserve Bank President Neel Kashkari, questioned the hike in his statement on Friday the necessity of a rate hike. Kashkari said in his statement that the labor market still shows signs of weakness and the inflation rate is still short of the 2 percent target.
The next weeks might be very exciting in the markets. Although it is generally accepted that a rate hike is bad for the stock market, and bullish for bond yields and commodities, the S&P index already surged 0.8 percent on Wednesday. Banks gain the most, as higher rates mean they are compensated more for lending. Construction and housing firms are usually hit the most, as higher borrowing costs prevent new construction projects. History shows that a week after a rate hike, on average since 1994, gold trades 0.13 percent higher, the 10-year T-Note falls 0.04 percent and S&P 500 loses 0.60 percent. The following graphic shows the U.S. Government bonds on Friday, March 17, 2017.
Another concern might be the U.S. dollar. An interest rate hike strengthens the U.S. dollar due to reduced inflationary pressure. With Trump’s promise on tax cuts and fiscal stimulus, the Fed would almost certainly need to hike faster, initiating a stronger dollar. Trump has already disapprovingly tweeted about a strong dollar, which would additionally raise an already record-high trade deficit.