Another Fed interest rate increase is likely this year, but no major impact is foreseen for financial markets.
Economic growth has been weaker than expected this year, with the economy sending mixed signals. During the first quarter, turmoil in financial markets, sharp declines in energy prices, and global economic risks raised much concern. Some talk of a possible recession surfaced. In this environment, the Federal Reserve has kept the federal funds rate unchanged after raising it in December for the first time in over nine years.
The statement from the April 27 meeting of the Federal Open Market Committee, the policymaking arm of the Fed, did not clearly map a path for future rate increases, and the market’s expectations about another rate hike in 2016 fell. But that changed with the release of the FOMC’s April meeting minutes on May 18.
In the minutes the Fed staff suggested a favorable outlook for economic growth, saying that “real GDP would expand at a modestly faster pace than potential output in 2016 through 2018, supported primarily by increases in consumer spending.” FOMC officials also said that “labor market conditions improved further,” and, “a range of indicators, including strong job gains, pointed to additional strengthening of the labor market.” About global risks, the minutes said, “while there had been recent improvements in global financial and economic conditions, downside risks to the forecasts from developments abroad, though smaller, remained.”
This positive outlook for economic conditions was interpreted as a signal that another rate increase is likely and could happen as soon as the June 14–15 FOMC meeting. In response, the market adjusted its expectations, as seen in federal funds futures contracts traded at the Chicago Board of Trade. Futures prices at the end of May (the latest data available for this issue) showed a 16 percent probability of a 0.25 percent increase in the federal funds rate in June. A rate increase by September is thought to be much more likely, with an estimated probability of 70 percent. And by December, from what we see in federal funds futures prices, at least one interest rate increase is virtually certain.
At the time we write this, the Fed’s June decision is unknown. However, past experience provides guidance about the likely effects of a rate increase, whenever it comes. Whether the Fed raises the target interest rate again in June or September, some immediate market reaction is inevitable. But what is really important are the longer-lasting effects.
Judging from past experience, a 0.25 percent increase in the federal funds rate would likely have a meaningful impact on the bank prime loan rate, but the effect on the stock market, the 30-year mortgage rate, and the 10-year Treasury yield would probably be insignificant. Chart 4 illustrates the after-effects of the previous interest rate increase in December 2015.
The bank prime loan rate, the rate at which banks lend money to their most credit-worthy customers, is closely connected to the federal funds rate. Last December, it jumped immediately after the Fed announced its rate increase—from 3.25 percent to 3.5 percent—and it stayed at the higher level. If the Fed raises the federal funds rate again, expect an equivalent increase in the bank loan rate. This means more expensive borrowing for businesses and individuals.
Stock markets can react swiftly to a rate increase, even dropping substantially, but they tend to rebound quickly. When the previous rate increase was announced on Dec. 16, 2015, the Standard & Poor’s 500 index of stocks declined for three days in a row but was back at its previous level within a week. (A much longer- lasting decline followed later, but it was driven by forces unrelated to the federal funds rate.)
Interest rates on 30-year mortgages and 10-year Treasurys were also largely unaffected by the small increase in the federal funds rate. When the next rate increase happens, these interest rates may move up or down in the short term, but over the longer term, a series of federal funds rate increases would likely push other interest rates higher.
To sum up, the market expects that a rate increase in September is more likely than in June. But in either case, there is no cause for panic, if the experience of the earlier rate increase is any guide. Small, well-anticipated federal funds rate increases tend to produce correspondingly small, if any, changes in long-term interest rates and financial markets in the ensuing weeks and months.