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Fed surprises with three rate hikes next year — and it could need to do more

The Fed surprised markets by forecasting three interest rate hikes next year, and that number could increase even more once President-elect Donald Trump takes office.

The Fed Wednesday raised rates for the second time in 10 years, boosting their short-term interest rate target by a quarter point to 0.50 to 0.75 percent.

In forecasts released after its meeting, Fed officials also indicated that they could hike the fed funds target rate three times next year, instead of the two quarter-point increases previously forecast for next year. They also raised the forecast for future years to three hikes in both 2018 and 2019.

Stocks traded sharply lower, while yields snapped higher. The 2-year Treasury yield, the most sensitive to the Fed, shot to a seven-year high of 1.27 percent. The dollar index also spiked, jumping 1.2 percent to 102.24.

"There's no mention of fiscal stimulus, so today's rate hike and the expectation for three next year — which is an increase of one hike — all reflects cumulative progress and expected progress against the dual mandate," said Ward McCarthy, chief financial economist at Jefferies.

Fed Chair Janet Yellen, during her post-meeting press briefing, said that some Fed officials considered the the president-elect's proposals in their projections. The Fed's interest rate forecast is presented as a chart, or "dot-plot" reflecting the anonymous views of Fed officials on where interest rates are heading.

"Some of the participants but not all of the participants did incorporate some assumptions of the change in fiscal policy into their projections," she said. "That may have been a factor that was one of several that occasioned these shifts."

The Fed had been expected to act based on the economic data it has seen in recent months, and not the promise of tax cuts and fiscal stimulus proposed by the incoming presidential administration of Donald Trump. The Fed's mandates are controlling inflation, which has been stubbornly low, and reaching full employment.

With November unemployment at 4.6 percent, the Fed is close to full employment. The Fed also mentioned in its statement that market expectations of inflation are rising.

The Fed could also raise its outlook for rate hikes further, after it sees what specific actions Washington will take next year.

"That's probably a reasonably good probability ... At this point they don't have enough information to change their perception of the outlook. However, I think that any changes of that nature would be in the second half of the year," said McCarthy. "The new president elect and the congress have to execute on the stimulus proposals, and as that happens, it will start to have ripple effects on growth and inflation forecasts."

Lindsey Group analyst Peter Boockvar said the stock market was responding to the prospect of more rate hikes, just as it did a year ago when the Fed forecast four rate hikes for 2016.

"I think the market is sniffing out the Fed is going to have to do what it didn't want to do. It's going to pick up the pace of rate hikes, and if they don't the market is going to do it for them," said Boockvar. "If they only do two to three, and the economy accelerates, and inflation picks up, the 10-year is going to 3 percent and the market is going to do it for them." The 10-year yield rose to 2.54 percent Wednesday afternoon.

John Canally, LPL Financial economist and market strategist, said both the market expectations and the Fed's previous forecast had been pointing to two rate hikes for next year. He said that was the first time in a long time that the Fed and markets were in agreement, and now the market view has to shift.

The Fed never raised rates as much as it forecast last year due to various events and market turmoil. Now, it has finally raised rates and even boosted its forecast.

"It's sort of a nod to the Trump administration. He sort of hinted rates should be higher. It's also a nod the economy is doing better," said Canally.

"The Fed says it will raise rates three times next year, and it may mean it this time," he said.