Fed Raises Key Rate, Balance Sheet Normalization to Accelerate in January


In its statement following its December 12-13, 2017 meeting, the Federal Open Markets Committee (FOMC) decided to raise the target range for the federal funds rate to a range of 1.25 to 1.5 percent, a decision that was widely expected. Despite the increase, the FOMC believes that the “stance of monetary policy remains accommodative”. As illustrated by the Federal Reserve Bank of Atlanta, the actual federal funds rate remains below the rate implied by the Taylor Rule.

The FOMC seeks to foster maximum employment and price stability, which is generally accepted as 2 percent inflation. In its statement, the FOMC noted that despite “hurricane-related fluctuations, job gains have been solid, and the unemployment rate declined further. However, “on a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year and are running below 2 percent. Market-based measures of inflation compensation remain low; survey-based measures of longer-term inflation expectations are little changed, on balance.”

While the majority of FOMC members voted for the rate hike, including Chair Yellen and Vice Chairman Dudley, two members, Charles Evans of the Federal Reserve Bank of Chicago and Neel Kashkari of the Federal Reserve Bank of Minnesota voted against this action “preferring to maintain the existing target range of the federal funds rate”, possibly in response to still low inflation. Despite the minority of detractors, the FOMC believes that its decision to raise the federal funds rate will support strong labor market conditions and a sustained return to 2 percent inflation”.

In addition to traditional monetary policy, the FOMC has also been normalizing its balance sheet since October. According to an implementation note issued on December 13, 2017, the FOMC will increase the level at which principal payments from its holdings will be reinvested, from $10 billion, $6 billion of Treasury securities and $4 billion of agency debt and agency mortgage-backed securities, to $20 billion, $12 billion of Treasury securities and $8 billion of agency debt and agency mortgage-backed securities. The increase will take place in January 2018. NAHB analysis demonstrated that the real return on 10-Year Treasury securities rose in October, the month that the Fed began normalizing its balance sheet.

The FOMC also released an advance copy of its Summary of Economic Projections. These projections indicate that the median FOMC member has become more optimistic about near-term economic growth and the unemployment rate since September. At the median, inflation is expected to return to its 2 percent level, unchanged from September.

Despite the improved expectation about the short-run performance of the economy, the median longer-run expectation did not change. More precisely, the median longer-run projection for real GDP growth remains at its potential rate. However, the ranges and central tendency for these economic indicators shifted somewhat.

According to the projections, the median projection of the federal funds rate implies three rate hikes in 2018. By 2020, the median expectation for the federal funds rate is now about 30 basis points above its longer-run level, exceeding the approximately 10 basis point median gap expected in September.

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