Fed raises interest rate and projects more hikes in 2017 to fight off inflation

Dec. 14, 2016 11:03 AM PT

Reporting from Washington —

A slowly improving economy and the possibility of higher inflation from President-elect Donald Trump’s proposed policies led Federal Reserve officials on Wednesday to hike interest rates for the first time in a year and signal three more small increases for 2017.

Although Trump’s plans — including business tax cuts and increased federal spending on defense and infrastructure — might have influenced the projections for the central bank’s benchmark rate next year, Fed Chairwoman Janet L. Yellen said she and her colleagues “are operating under a cloud of uncertainty at the moment.”

She said they will have to see what proposals are put into law before taking action.

Fed officials have been hesitant to increase the federal funds rate too quickly out of concern it could cause the still-recovering economy to stumble. Wednesday’s hike of a quarter percentage point, approved unanimously, was just the second increase in more than a decade.

“It is a vote of confidence in the economy,” Yellen said at a news conference.

Financial analysts said the rate hikes should filter down in the form of higher loan rates and interest on savings accounts. Consumers and businesses have already seen borrowing costs climb, a sign that investors expect stronger economic growth and rising inflation.

Yields on the benchmark 10-year U.S. Treasury note have risen to their highest levels in more than a year. The yield on the 10-year Treasury note has climbed from 1.57% on Sept. 1 to 2.57% on Wednesday.

That has driven mortgage rates to new highs as well. The average interest rate on a standard 30-year mortgage jumped from 3.54% the week before the election to 4.13% at the end of last week, according to government-backed mortgage buyer Freddie Mac.

Some analysts expect rising rates to eventually trickle through to savers as well.

“This single quarter-point move in interest rates will go largely unnoticed at the household level, but coupled with last year’s hike, the cumulative effect could mount quickly if the Fed quickens the pace of rate hikes in 2017,” said Greg McBride, chief financial analyst at Bankrate.com.

Since election day, the Dow Jones industrial average has jumped about 8% to record highs. It dropped about 166 points after the Fed announcement and Yellen’s comments before recovering somewhat. The Dow closed down 119 points, or about 0.6%, at 19,792.53

The federal funds rate applies to short-term lending between banks, but it has become a benchmark for consumer and business loan rates.

Fed officials had telegraphed the move in recent weeks, so financial markets had already adjusted. Because of that Yellen said she anticipated that “households and firms will see very modest changes from this decision.”

“It could boost very slightly some short-term interest rates that could have an effect on borrowing costs that are linked to them,” she said.

The federal funds rate still is extremely low by historical standards – after Wednesday’s hike it will be between 0.5% and 0.75%. It was above 5% as recently as 2007.

But the rate is slowly moving up from the unprecedented near-zero level at which the Fed held it for seven years to try to stimulate the economy during and after the Great Recession.

In a statement after a two-day meeting, members of the Fed’s Federal Open Market Commission were more upbeat about the U.S. economy than after their November meeting.

“We expect the economy will continue to perform well,” Yellen told reporters.

The Fed generally raises the rate to prevent the economy from causing prices to rise too much.

Although the Fed signaled three more quarter-point hikes in its benchmark rate for next year, David Shulman, senior economist at UCLA, said he and his colleagues at the UCLA Anderson Forecast now see at least four rate increases in 2017.

That is because economists are expecting stronger economic growth and rising inflation as the Trump administration, with a Republican Congress, could push through tax cuts, infrastructure spending and rollbacks in business regulations.

With the labor market already tight — the unemployment rate was 4.6% in November, the lowest since 2007 — faster economic growth will probably push up workers’ pay as well. Annual wage increases could jump next year to 4% from about 2.5% this year, said Shulman.

At the same time, higher interest rates could slow construction and the housing market.

Shulman’s advice for those on the fence concerning home buying and refinancing loans: “Better to do it now than later because it’s going to get more expensive.”

Fed policymakers slightly upgraded their projections for economic growth, to 1.9% for this year and 2.1% next year.

They also indicated the economy is just about at full employment, projecting the unemployment rate would inch down to 4.5% next year and stay there through 2019.

With a more optimistic view of economic growth, and a projection that the inflation rate will hit 1.9% next year, Fed policymakers increased their expectations for rate hikes next year to three from a September forecast of just two.

It was almost exactly a year ago that the Fed inched up its benchmark interest rate for the first time since 2006. The rate in June 2006 was increased to 5.25%, but a little more than a year later the Fed began lowering it in response to the economic slowdown that led to the Great Recession.

When Fed officials nudged the rate range up by a quarter of a percentage point a year ago, they indicated four more small hikes were coming in 2016.

But the year began with financial market turmoil triggered by fears of a global economic slowdown. After that abated, uncertainty arose in financial markets, first because of the British vote on leaving the European Union and then surrounding the U.S. presidential election.

Those factors led the Fed to hold off on any more rate hikes.

During the final months of the campaign, Trump accused Yellen of keeping the rate “artificially low” to help fellow Democrats President Obama and presidential nominee Hillary Clinton.

Historically, the independent Fed’s desire to appear nonpartisan has meant it rarely increases the rate in the weeks before a presidential election.

Despite Trump’s criticism, Yellen reiterated that she intended to serve out her four-year term as chairwoman, which ends in February 2018. She could remain on the Fed’s Board of Governors until 2024 but said, “that is a decision for another day.”

“The term of the Fed chair was not meant to coincide with that of the president. And there were good reasons for that too,” she said. “It’s part of ensuring the independence of the Fed.”

Yellen cited that independence in declining to comment on the potential negative effects of Trump’s tweets criticizing specific companies, such as one about Boeing Corp. last week that caused its stock to drop.

“I’m not going to offer the incoming president advice about how to conduct himself in policy,” she said.