Fed Hikes, Hints 'Neutral' Is Near

By Charles Tan - December 19, 2018

There was no Santa surprise from the Federal Reserve (Fed) today. In a widely expected move, the central bank lifted the federal funds rate target 25 basis points, to a range of 2.25 percent to 2.50 percent. This marks the central bank’s fourth rate increase of 2018 and its ninth tightening move since lifting rates from their near-zero level in December 2015.

The Fed cited continued strong economic activity, including jobs and household-spending growth, as reasons to boost its key lending rate. The Fed also noted inflation remains near the 2 percent target, and longer-term inflation expectations remain unchanged.

Perhaps more important, the Fed provided some clarity to investors seeking clues to the central bank’s economic outlook and future rate-hike plans. Last month, Fed Chair Jerome Powell indicated that rates were “just below” neutral, the level at which they neither spark nor stifle economic growth. At today’s monetary policy meeting, Fed officials reduced their estimates of what constitutes a “neutral” rate from 3.00 percent to 2.75 percent. This implies the Fed is potentially one hike away from that neutral level.

Data Suggest a Slower Path Is in Order

Three months ago, the Fed suggested it may raise rates three times in 2019. Today, it appears the central bank may pursue a slower path to higher rates. In its post-meeting statement, the Fed noted “some further gradual increases” in interest rates will be consistent with sustained economic growth, strong labor markets and target-level inflation. Most Fed officials now forecast no more than two rate increases in 2019.

We have a slightly different outlook, given recent global economic trends. Specifically, global growth continues to slow amid trade tensions and Brexit uncertainty, curbing an important tailwind for U.S. growth. Against this potential backdrop, we expect the Fed will need to raise rates only one time in 2019 to meet the dual goals of price stability and maximum employment.

Economic Outlook Shows Little Change

Fed policymakers made only modest revisions to their economic outlook. They slightly reduced their economic growth outlook for 2018 to 3.0 percent, down from 3.1 percent in September. They also lowered their growth forecast for 2019, from 2.5 percent to 2.3 percent. However, the Fed’s long-term growth expectations inched higher, from 1.8 percent to 1.9 percent.

The Fed’s 2018 and 2019 unemployment forecasts remained unchanged at 3.7 percent and 3.5 percent, respectively. These rates remain lower than the Fed’s estimates of long-run unemployment, which range from 4.0 percent to 4.6 percent. This outlook suggests the Fed expects the labor market to exceed the central bank’s long-standing guidelines for “full employment.” If these expectations prove correct, strength in the jobs market likely will trigger rising wages, which eventually would create inflationary pressures.

In the meantime, the Fed expects core inflation, which excludes food and energy prices, to end the year up 1.9 percent, slightly below its earlier projection of 2.1 percent. The Fed expects inflation to inch back up to its target level of 2 percent in 2019.

Treasury Yields Remain Rangebound

After soaring to multi-year highs earlier in the year, U.S. Treasury yields declined in recent weeks in response to sharp stock market volatility. Given our expectations for healthy growth, stable inflation and a more-dovish Fed—combined with an increase in Treasury supply—we expect Treasury yields to trade within a fairly narrow range. We believe the 10-year Treasury yield will settle in a range of 2.75 percent to 3.25 percent over the next few months.

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      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.

      Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.