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Econometric Advisors' blog

December rate rise: Fed raises rates as expected; three more hikes likely in 2018

Dec 14, 2017, 13:42 PM by Jeff Havsy
  • The Federal Reserve raised the federal funds rate by a quarter point today to a target range of 1.25% to 1.50% and is likely to make three more hikes in 2018 if the current high level of momentum continues.
  • The Fed’s rate outlook will also depend on the scope of tax reform that might be adopted in the coming months and its potential stimulative effect on the economy.
  • Despite the Fed’s three earlier 0.25% interest rate increases since December 2016, cap rate changes have been muted as long-term interest rates have decreased due to the continued accommodative stance of central banks outside the U.S.
  • With Jerome Powell expected to take over the Fed’s reins on February 3, and President Trump appointing two new governors, the FOMC will look a great deal different in 2018. This does not necessarily mean a change in policy direction for the Fed.

The Federal Reserve today raised the target range for the federal funds rate by 25 basis points (bps) to a target range of 1.25% to 1.50%. This was the Fed’s fourth 25-bps increase since December 2016 and was widely anticipated given the economy’s recent near-3% quarterly growth, robust job growth, record low unemployment, modest wage gains and rising consumer and producer prices.

On the inflation front, higher energy prices account for a sizeable part of the increase in the Consumer Price Index. November saw increases in the prices of new cars, trucks, transportation & warehousing activities and travel-related services. On the producer front, costs of partially finished goods and raw materials have climbed to the highest levels since April. Although inflation has remained low this year despite an ultra-tight labor market, the re-emergence of some inflationary pressure in November, coupled with solid economic data, was reason enough for the Fed to raise rates. 

The underlying trend in economic growth—steady at 2% in recent years—should continue, while there has recently been some encouraging news on the productivity front. 

In addition to generally good underlying economic conditions, commercial real estate fundamentals—particularly in the industrial sector—remain strong, and continued strong economic growth in Q4 should keep them healthy for at least the first half of 2018. Cap rate increases have been relatively low, as the long end of the curve has decreased in 2017. Most of the very modest cap rate softness in 2017 is related to fundamental concerns about certain market/asset types being near the top, in addition to some secular concerns about retail.

Although the Fed’s raising of rates was largely expected, markets were looking for more insight into how the Fed plans to further normalize rates in 2018. While the Fed’s forecast indicates three rate hikes next year, any increase in concern over fiscal policy (i.e., tax reform) and its effect on inflation will likely be reflected in the Fed’s projections. Tax reform may drive down the unemployment rate to as low as 3%, as private investment may increase and thus lead to further job creation and wage growth. On the other hand, productivity may continue to grow and the labor force participation rate could increase. We think that inflation will gently pick up and the risks are moderately to the upside.

 

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