Fed Rate Hike Cites Strong Labor Conditions, Inflation

You can’t say you weren’t warned: The Federal Reserve has been hinting all year that it would raise the federal funds rate at its December meeting, and by golly, it did.

Following its policy meeting yesterday, the Federal Open Market Committee announced it raised the federal funds rate a quarter-point to 1-1/4 to 1-1/2 percent. In its statement, the FOMC noted the labor department “continued to strengthen” and economic activity “has been rising at a solid rate.”

“In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1 1/2 percent,” the statement said. “The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.”

Mortgage Bankers Association Chief Economist Mike Fratantoni said the long-telegraphed rate hike came as no surprise. However, he noted the FOMC “markedly increased” its forecasts for economic growth in 2018, with the unemployment rate expected to average 3.9 percent over the next two years, well below the long-run sustainable rate of 4.6 percent.

“With this optimistic outlook, driven in part by the spur in demand expected from the tax cuts, it is surprising that the Fed still expects just three rate hikes next year,” Fratantoni said. “We think they are likely to revise up this guidance early next year to show four hikes in 2018.”

Fratantoni said the stronger job market is likely to lead to faster wage growth, but inflation to date remains below the Fed’s target of 2%. “For this reason, there were two dissenting votes at this meeting,” he said. “These members [Charles Evans and Neel Kashkari] preferred to keep rates unchanged at this point. However, it’s important to note that voting members of the FOMC change come January, with a more hawkish set of members casting votes in 2018.”

Mortgage rates have remained in narrow range in 2017, Fratantoni added. “The Fed’s expected path of increasing short-term rates and continuing to shrink its balance sheet over the next few years will put upward pressure on mortgage rates in 2018, but we expect that short rates will continue to increase faster than long rates, leading to a flatter yield curve,” he said. “We do expect that mortgage rates may also become somewhat more volatile in the year ahead, particularly as the Fed allows its [mortgage-backed securities] portfolio to run off at a faster rate through the course of the year.”

Cheryl Young, senior economist with Trulia, San Francisco, said in the long run the federal funds rate and the 30-year fixed mortgage rate are highly correlated, but Fed rate hikes this year did not always lead to increases in mortgage rates.

“Mortgage rates would have to rise to levels unseen since 2011 to have any impact on the home buying decision,” Young said. “If mortgage rates increase 0.8 percentage points to 4.6% in San Jose, Calif. the cost of buying will equal renting. Nationally, the 30-year fixed mortgage rate would have to rise to 8.3%–or 4.5 percentage points higher than they are today–for the cost home buying to equal the cost of renting.”

Aaron Terrazas, senior economist with Zillow, Seattle, agreed. “This move has been widely anticipated for several weeks, and the hike was largely priced into markets already,” he said. “Additionally, a lot of faces will change at the Federal Reserve beginning in 2018–including a new Chair and a new slate of FOMC voters–so markets will probably place less emphasis than usual on today’s news.

But Terrazas cautioned low mortgage rates “can’t last forever. Though they may not approach historic highs any time soon, sooner or later they will increase, eating into what buyers can afford to pay.” He said Zillow expects mortgage rates to end 2018 at 4.5 percent, 75 basis points higher than their current levels.

Tendayi Kapfidze, Chief Economist with LendingTree, Charlotte, N.C., Suggested balance sheet reduction may be more important than the Fed Funds rate itself.

“To help recovery from the financial crisis, the Federal Reserve grew its balance sheet by purchasing treasuries and mortgages to keep interest rates low, this was known as quantitative easing,” Kapfidze said. “The Fed believes the economy is now stronger and needs less support, thus it began reducing its balance sheet in September. Average 30-year fixed mortgage rates reported by Freddie Mac have trended upwards 16 bps to 3.94% from 3.78% since the Fed began to reduce its balance sheet and the FOMC statement reiterated this commitment to balance sheet reduction.”

The full FOMC statement appears below.

“Information received since the Federal Open Market Committee met in November indicates that the labor market has continued to strengthen and that economic activity has been rising at a solid rate. Averaging through hurricane-related fluctuations, job gains have been solid, and the unemployment rate declined further. Household spending has been expanding at a moderate rate, and growth in business fixed investment has picked up in recent quarters. 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.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Hurricane-related disruptions and rebuilding have affected economic activity, employment, and inflation in recent months but have not materially altered the outlook for the national economy. Consequently, the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12 month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee’s 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1-1/4 to 1 1/2 percent. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2 percent inflation.

In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal. The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; 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.

Voting for the FOMC monetary policy action were Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Patrick Harker; Robert S. Kaplan; Jerome H. Powell; and Randal K. Quarles. Voting against the action were Charles L. Evans and Neel Kashkari, who preferred at this meeting to maintain the existing target range for the federal funds rate.”