Markets are skeptical Fed will stick to its rate hiking plan

  • The Federal Reserve maintained its forecast for three interest rate hikes next year, but the stock market is skeptical because of low inflation.
  • In her final briefing, Fed Chair Janet Yellen said the central bank is monitoring low inflation and it remains a risk to policy.
  • The Fed statement acknowledged that inflation has actually declined, instead of just noting that it's soft.
  • The reference to lagging inflation cast some more doubt on the Fed's ability to hike rates three times next year.

The Federal Reserve maintained its forecast for three rate increases in 2018, but markets remain skeptical it can hike even twice.

One key reason behind the market skepticism is sluggish inflation.

The Fed raised interest rates by a quarter point, as expected Wednesday but the market continued to price in just about two hikes for 2018. In a report earlier Wednesday, November core CPI rose 1.7 percent on an annual basis, down from 1.8 percent in October.

Fed Chair Janet Yellen, at her post-meeting briefing, described continuing low inflation as a concern and a potential risk to policy.

Federal Reserve Board Chairwoman Janet Yellen
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Federal Reserve Board Chairwoman Janet Yellen

"My colleagues and I continue to believe the factors that are responsible this year for holding inflation down are likely to prove transitory. That said we all agree our inflation objective is important," she said. The Fed inflation target is 2 percent.

According to Aaron Kohli, fixed income strategist at BMO, fed funds futures fluctuated slightly after the 2 p.m. ET Fed statement, and were pricing in slightly less than two rate hikes for next year.

Kohli said the market responded to the "notion the Fed is being more cautious," based on its language about inflation. He noted the central bank changed the language in its statement from noting inflation is soft to noting it declined.

"On a 12-month basis, both overall inflation and inflation for items other than food and energy have declined this year and are running below 2 percent," the Fed said in its statement.

"The market is in a 'show me' state for a good reason," said Ward McCarthy, chief financial economist at Jefferies. McCarthy said when Jerome Powell likely takes over as Fed chair in February, the central bank may have a different view on inflation and the economy, and it will take awhile to change the market's view.

"They said as little as possible about inflation. The bottom line is they don't understand what it's doing but it's not stopping them from normalizing," he said. "First of all this is a transition period from Yellen to Powell, so they're not going to make any big statement until March" when Powell is likely chair.

McCarthy said the market may expect two hikes, but he sees the potential for four hikes in 2018.

Treasurys gained, and yields, which move opposite price, fell. The two-year yield dipped to 1.78 percent, and the 10-year yield was steady at 2.36 percent, well below its highs of earlier in the day when it crossed 2.42 percent.

The stock market gained slightly after the Fed's 2 p.m. ET statement, and the dollar was slightly lower.

The Fed hiked its GDP forecast for 2018 to 2.5 percent, up 0.4 percent. Yellen said the forecast incorporated some FOMC members' views on how tax cuts could impact the economy, but strategists said the forecasts appeared to reflect the current momentum in the economy with little added for taxes.

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