As expected, the Federal Reserve (the “Fed”) at its December 2015 meeting raised the Fed Funds rate (the overnight interbank rate) by ¼% to a range of ¼% to ½%. This was the first rate hike in 9 ½ years. The Fed expects to raise rates by another 1% before year end 2016. By historical standards, this would be viewed as gradual, i.e. a ¼% rate hike every quarter versus a rate increase every six weeks in prior tightening cycles.
Our sense is that even this timeline outlined by the Fed may prove to be aggressive and the actual pace may be slower. U.S. interest rate policy has diverged from that of most other major economies. While our central bank is tightening, foreign central banks continue to take policy measures to flood their economies with liquidity to spur sluggish growth. All things being equal, this policy divergence will lead to higher interest rates here than abroad. This will tend to strengthen the dollar and suppress inflation reducing the need for a rapid series of rate increases.
Investors initially responded favorably to the Fed’s move as the Dow Jones Industrial Average rallied more than 200 points. The Fed demonstrated its confidence in the economy’s ability to grow by finally lifting interest rates above zero. For savers, this is obviously good news. For borrowers, this is hardly the end of the world. We expect increases in longer-term rates will be muted in part due to relatively limited supply of quality assets. Given the disparity between U.S. and foreign interest rates, the U.S. will continue to attract ample foreign capital to our bond market holding bond yields down. Mortgage rates may move up from current levels but the increase will probably fail to keep pace with the rise in short-term rates.
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