The Federal Open Market Committee (FOMC), which is the policy-making arm of the Federal Reserve, raised interest rates by a quarter of a point at the conclusion of its two-day March meeting.
However, the rate hike itself wasn't the most interesting result of the Fed's meeting. In fact, the market had been pricing in a 95% chance of a rate hike. On the other hand, there are some other key takeaways from the Fed's meeting that could have major implications for investors.
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Rates could rise faster than expected
I briefly mentioned that the recent quarter-point rate hike was priced in to the market. For a little more color, the FOMC releases a document known as a "dot plot" four times each year, which contains the FOMC members' projections of where rates are headed over the past few years. This lets the market know what to expect.
As an example, the previous dot plot, released in December 2017, showed that the FOMC participants expected three rate hikes in 2018. When combined with recent economic improvements and potential tailwinds like tax reform, this led the market to believe a March rate hike was coming.
Here's the point: The March dot plot that was just released now shows rates rising more rapidly than the previous one did. Instead of a firm consensus of three rate hikes in 2018, members are now split between three and four. And between 2019 and 2020, FOMC participants now see one additional rate hike.
Expectations for the year-end Federal Funds Rate, which is now set at a target range of 1.50% to 1.75%, remained unchanged at 2.1% for 2018. However, the 2019 target is now 2.9%, up from 2.7%, and the 2020 target has risen even more, from 3.1% to 3.4%. In other words, the FOMC now expects to raise interest rates another seven or eight times by the end of 2020.
The Fed sees GDP and unemployment improving
According to the FOMC statement, "The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong."
Putting some numbers behind this statement, the Fed now expects 2.7% GDP growth in 2018, up from 2.5% in December's forecast. For 2019, GDP growth is now expected to be 2.4%, up from a projected 2.1% previously.
The Fed also expects unemployment to get even better than it previously thought:
Inflation projections remain surprisingly low
It's no secret that the Fed's target is a 2% inflation rate. And it looks like we'll be around that level for the foreseeable future, as the Fed sees 1.9% inflation this year, followed by 2% in 2019 and 2.1% in 2020. In its statement, the FOMC said, "Inflation on a 12-month basis is expected to move up in coming months and to stabilize around the Committee's 2 percent objective over the medium term."
However, an important takeaway is that these are extremely low inflation rates for such strong labor market projections. For example, consider that when unemployment fell to about 4% in late 1999, inflation soared to well over 3%.
The interest rate increase could push bank earnings higher
I recently wrote an article detailing how the Fed rate hike could affect consumer interest rates, such as those charged for mortgages, credit cards, and auto loans.
One thing investors should take note of is that this could positively impact bank earnings.
A simplified version of how banks make their money is that they take money in as deposits, and then lend that money out at higher rates. Generally speaking, the interest rates banks charge on loans tend to increase faster than their cost of deposits. Just look at the current rate hike cycle: The Fed has hiked rates six times, but many savings account interest rates have barely budged. Plus, many deposits (like standard checking accounts) generally don't pay any interest at all.
In short, the Fed rate hike could lead to better profit margins for banks. Most importantly, the increased rate hike forecast I discussed earlier could translate to higher-than-expected future income.
The Fed expects the economy to cool off after 2020
As you can see, the general theme is that the economy is forecast to improve more than expected, and rates are now expected to rise slightly faster as a result.
However, an interesting point to keep in mind is that the longer-term interest rate forecast on the dot plot is 2.9%. This is up from 2.8% in December's dot plot, but the point is that it's significantly below where the Fed sees rates going by 2020.
If you're not too familiar with how the Fed decides interest rate policy, rates generally rise during strong economies, and they tend to drop when the economy starts to cool off. So, the latest dot plot implies that the economy could cool off after 2020. This makes sense -- after all, the Fed's longer-run GDP growth forecast is 1.8%, as compared to 2.7% expected this year and 2.4% expected in 2019.
Will inflation start to climb?
Inflation is a key number to watch going forward. If inflation turns out to be higher than the Fed's projections, it could lead to more rate hikes than are currently called for. Conversely, if inflation turns out to be lower than expected, the Fed could be more cautionary and keep rates lower.
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