Investment Outlook

The Fed’s June meeting: Hikes continue amid geopolitical noise

Brian Nick, CAIA
Chief Investment Strategist,  Nuveen
Key points
  • On June 13, the Federal Reserve (Fed) raised its target benchmark interest rate, the fed funds rate, by 25 basis points (0.25%), to a target range of 1.75% to 2.00%. This is the second hike in 2018 and the seventh of the current cycle.
  • In its accompanying statement, the Fed once again upgraded its assessment of the U.S. economy. Officials now believe the unemployment rate will fall further to 3.6% this year, from an 18-year-low of 3.8% in May.
  • The Fed’s median forecast for the fed funds rate rose to 2.4% (from 2.1%) for 2018 and to 3.1% (from 2.9%) for 2019.

What happened?

Despite a notable rise in geopolitical risk that briefly threw the outcome into doubt, the June Federal Open Market Committee (FOMC) meeting produced the expected result. The FOMC raised its target fed funds interest rate by 25 basis points—the seventh hike since 2015—to a range of 1.75% to 2.00%, still a historically low level. The Fed also modestly raised its expectations for the path of future hikes through 2019. For the first time, the median FOMC member expects a total of four rate hikes this year, up from just three at the March meeting.

As we have highlighted throughout this hiking cycle, the Fed is merely responding to incoming economic data when it projects a more hawkish monetary policy moving forward. A rebound in consumer spending, coupled with evidence of stronger business investment and more government stimulus in the pipeline, will likely keep growth humming even as the Fed raises rates. The FOMC’s statement acknowledged the recent strength in both job gains and business fixed investment.

Why does the Fed's action matter?

The Fed continues to look beyond the day-to-day noise of global politics and trade negotiations, something the financial markets have had trouble doing of late. The FOMC clearly does not expect current tensions between the U.S. and its largest trading partners to spiral into a full blown trade war, which could depress confidence and, ultimately, growth.

Instead, by offering a positive assessment of the U.S. economy, the Fed has validated the year-to-date rise in short-term U.S. Treasury yields and indicated that both short- and long-term interest rates may yet need to move higher. At its currently projected pace, the Fed will reach its own definition of a “neutral” target rate—one that neither accelerates nor restrains the economy—of approximately 2.9% by this time next year.

What was the market reaction?

Markets initially seemed to latch onto the absence of a passage in the Fed’s statement that, for years, has conveyed expectations that the federal funds rate would remain below its longer-run average. In addition, the Fed’s median forecasts for growth and inflation in 2018 rose, while its outlook for unemployment fell.

The 10-year U.S. Treasury yield climbed modestly to 2.98% from 2.95% in the minutes following the statement’s release. Equity markets dipped slightly on the hawkish interpretation.

The FOMC has convinced markets that it is on a steady path to normalizing interest rates, barring significant changes in the data. As a result, meeting dates are less likely than they have been historically to produce spikes in volatility. Instead, the most important data releases between meetings (e.g., employment, PCE inflation and labor costs) should drive the market’s views about evolving Fed policy. This data dependency is a welcome change for markets (and, we suspect, for the Fed) from the days when monetary policy was seen as a tool for boosting the economy rather than a dependent variable shifting in response to changing circumstances.

What is our outlook?

The Fed is likely only halfway done raising rates for the year. We expect another two 25-basis-point hikes (one each at the September and December meetings), for a total of four in 2018, as well as at least two more in 2019. Household spending has bounced from a tepid first quarter as incomes continue to rise. Private investment is surging, and more federal stimulus will arrive in the coming months. Inflation is unlikely to accelerate to uncomfortably high levels anytime soon, but the Fed appears satisfied that it has largely reached its 2% target and is now focused on bringing rates back up to normal.

For the time being, financial conditions remain loose, encouraging risk-taking by investors and employers. While long-term U.S. interest rates may continue to climb (albeit at a more modest trajectory), we view higher Treasury yields less as a threat to stronger growth and more as a symptom of it.

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Definitions

The Federal Open Market Committee (FOMC) holds eight regularly scheduled meetings per year to review economic and financial conditions, determine the appropriate stance of monetary policy and assess the risks to its long-run goals of price stability and sustainable economic growth.
A basis point is a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01%.
PCE inflation (personal consumption expenditures inflation) is a United States-wide indicator of the average increase in prices for all domestic personal consumption.

Source
Federal Reserve Statement, June 2018.
Bloomberg.
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