Market update: Fed Raises Rates and Steepens the ‘Dot Plot’

As widely expected, last night the US Federal Reserve raised policy rates by 0.25%. This unanimous decision takes the Fed Funds Rate to a range of 1.50% to 1.75%

Also expected were increased forecasts for both US inflation and growth. Soft consumption and investment data seen in Q1 is seen as transitory. The GDP forecast for 2018 was raised to 2.7% from 2.5% and in 2019 from 2.1% to 2.4%. Core inflation forecasts for 2018 and 2019 edged up to 2.1% from 2.0% previously.

The Fed frustrated some of the more hawkish market predictions and stuck to its implied three-hike dot plot for 2018. Before the meeting, the market had been pricing a one in three chance of four or more hikes. However the distribution of forecasts for 2018 is somewhat top-heavy, so four or more hikes is not entirely taken off the table.

For 2019 and beyond, the Fed steepened the implied path of rates markedly. In December only two quarter point rate increases were projected for 2019. This has now become three. This is set against a market that had been priced just 0.4% of tightening in 2019 prior to the Fed decision. A further two quarter-point hikes are implied for 2020, which would take the Fed Funds rate to a range of 3.25% to 3.50%.The market is pricing in just 2.60% for that year.

The market reaction to these developments was a little confused. While it can be argued that the US rate outlook for 2018 is a little more benign than previously thought, this is certainly not the case further out. Nevertheless, the US Treasury yield curve registered  an overall downshift and the dollar weakened. Equity market volatility picked up significantly in the aftermath.

Although the language of the Fed remains the same, it’s ‘reaction function’ seems to be shifting. It remains to be seen if this is also reflected in the Bank of England’s rate decision later today.