The Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) met June 13-14 and voted to increase the federal funds rate by 0.25%. The move was once again anticipated following strong hints by Fed officials in public appearances, making the market impact minimal. Similar to the last hike, Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, voted to leave the rate unchanged. The FOMC cited a recent pickup in household spending, expanding business investment, and moderating job growth as the primary drivers of current economic conditions. Effective June 14, the prime rate increased to 4.25%.
The Fed voted to continue re-investing maturing Treasury securities, agency debt, and agency mortgage-backed securities, explained in a previous edition of INTERESTing Times. However, the FOMC issued a plan describing intent to begin reducing its balance sheet later this year by gradually reducing re-investment as those securities mature. While no firm date was established for the initiation of this action, the bond market anticipates the Fed will begin in late 2017.
The FOMC will start with a reduction in its re-investment policy at a level of $6 billion per month in the Treasury market and $4 billion per month in the agency and mortgage-backed securities market, with increases every three months until it hits $30 billion per month in Treasurys and $20 billion per month in agency and mortgage-backed securities.
At that speed, it will take until early 2019 before the Fed reaches its stated taper level and several years for its balance sheet to shrink to a more normal level. Fed officials do not anticipate returning to the pre-crisis level, $800 billion balance sheet. As stated in the most recent edition of INTERESTing Times, the Fed’s monetary policy will still be considered accommodative until the balance sheet reaches a stabilized level and the federal funds rate reaches a normalized level.
The next Fed meeting is July 25-26. The futures market currently projects a less than 5% chance of a rate hike at this meeting and minimal chances of a rate hike in September or October. However, the futures market is currently predicting a 47% chance of another quarter point rate hike at the December FOMC meeting.
Updated Economic Projections
The Federal Reserve Board members released their quarterly economic projections at the June meeting. There was little change from March projections with real gross domestic product growth of 2.2% in 2017 and tapering down to a long-run growth rate of 1.8%. The Fed projects an expected rise in the federal funds rate by an additional quarter point this year, three quarter point increases in 2018, and three more quarter point increases in 2019 to reach a longer-run level of 3.0%. Today, the federal funds rate is 1.25%.
Impact on Interest Rates
Variable rate loans have increased along with the federal funds rate. The Wall Street Journal prime rate is now at 4.25%. However, the market for longer-term loans has not increased as much as expected with the increases in short-term rates. This has kept long-term loan rates such as home mortgages and farm real estate loans much lower than anticipated. How much longer this phenomenon will last is the INTERESTing question.
If the Fed’s long-term federal funds rate projections are correct, longer-term, fixed rate loans will likely rise if the short-term rates continue to increase as fixed income buyers won’t want to buy long-term bonds if there is no premium attached to having the money tied up for the duration of the bond. For example, why would a bond buyer purchase a 10-year U.S. Treasury bond yielding 2.2% when a 2-year U.S. Treasury would yield more if the federal funds rate is increased four times over the next year?
The Fed will either not be able to increase short-term rates as they project, or else long-term rates will head higher. Have you mitigated the risk of higher interest rates on your long-term debt? If not, now might be a good time to see if an adjustable or long-term fixed rate option might be in your long-term best interest as we do indeed live in INTERESTing times.