Fed hike and economic forecast seen as a double-edged sword for markets

  • Markets saw the Fed's rate hike and forecasts as good news for risk markets since officials are more optimistic about the economy.
  • But the double-edged sword is that the Fed is also moving ahead on a more aggressive rate-hiking path in the future.
  • The Fed, as expected, raised the Fed funds target rate range by a quarter point to 1.50 percent to 1.75 percent.
  • The Fed kept the number of rate hikes expected for 2018 at three, though some economists had expected a fourth hike. But it did increase its long run rate to 2.9 percent, from 2.75, and forecast three rate hikes each in 2019 and 2020.
Federal Reserve Chairman Jerome Powell speaks during a news conference in Washington, DC.
Getty Images
Federal Reserve Chairman Jerome Powell speaks during a news conference in Washington, DC.

Markets saw the Fed's rate hike and forecasts as initially good news for risk markets since officials did not add another rate hike for this year and are more optimistic on the economy.

But the double-edged sword is that the Fed is also more hawkish, or more willing to move ahead with interest rate hikes.

As expected, the Fed raised the fed funds target rate range by a quarter point to 1.50 percent to 1.75 percent. It kept the number of rate hikes expected for 2018 at three. But it did increase its long run rate to 2.9 percent, from 2.75, and added rate hikes in 2019 and 2020.

"They certainly sound more optimistic," said Mark Cabana, head of U.S. short rate strategy at Bank of America Merrill Lynch. "I am a bit impressed by the fact that they not only revised up growth but they revised up inflation. ... The market may have been expecting a little bit more in terms of a rate move for 2018."

Stocks initially rallied and the Dow surged 100 points just after the 2 p.m. announcement from the Fed. Some of the rally was relief that the Fed did not add a fourth rate hike for this year as some expected.

But those gains were wiped out later as Fed Chair Jerome Powell briefed journalists.

Michael Arone, State Street Global Advisors chief investment strategist, said the stock market was confused by the fact the Fed sounded optimistic in its forecasts but when it came to its statement it said economic activity rose at just a "moderate" pace since it met in January versus the solid pace it had seen.

"The market is confused by the contrast between the statement and the summary of economic projections, and they're not able to determine what's next," Arone said. He said the market initially rallied on positive growth forecasts, but investors later considered the fact that the fed did not see much inflation.

Arone noted the Fed raised GDP forecasts for 2018 and 2019 and lowered the unemployment rate for 2018 and 2019, but inflation forecasts did not move much higher. The Fed forecast GDP at 2.7 percent this year, up 0.2 percent, but inflation is expected to rise to just 1.9 percent in 2018. The Fed's target is for 2 percent inflation, and it forecast a 2 percent level by 2020 and 2.1 percent in 2021.

In response to a question, Powell addressed the fact that the Fed is hiking while inflation is not seen rising that much. He said the Federal Open Market Committee wants to take the "middle ground." He said the Fed does not want policy to lag so much that it will have to speed up rate hikes, but it can't raise rates so quickly that inflation won't get a chance to increase.

"The big picture is they expect to continue to raise rates three, maybe four, times this year and they expect to raise rates three times next year, more now than they did back in December, but they're not in a rush," said Ward McCarthy, chief financial economist at Jefferies.

The bond market had a mixed reaction, with the 2-year Treasury yield slipping and the longer-term yields rising. The 2-year, falling to 2.30 percent, is most reactive to near-term Fed policy moves.

"The front end is seeing a small relief rally," said John Briggs, head of strategy at NatWest Markets. He said the 10-year Treasury yield, off its highs at 2.89 percent, was higher in response to the Fed's higher long run rate.

Briggs also said he expects the Fed to ultimately move up to four hikes this year, but they will wait for more economic data to make that call.

"The hawks are thinking we could have a higher neutral rate. They added a line saying the economic outlook strengthened in recent months. But I think that just reinforces the idea that come June, they're going to be talking about four hikes," said Briggs.

McCarthy said the tone of the Fed's statement suggests Fed officials are incorporating the impact of fiscal stimulus in their forecasts.

"With increased fiscal stimulus, the [improvement] of the economic data and the likelihood that economic prospects continue to improve, FOMC policymakers want to pursue monetary policy normalization process at a somewhat faster pace, but do not want to foster the impression that they will be aggressive and risk an economic downturn," noted McCarthy.