Bank of the West US Outlook Report for December 18, 2015

US Outlook Report: FOMC Signals a Return to Normalcy

Citing considerable improvement in labor market conditions – specifically job gains, declining unemployment, and diminished underutilization of labor resources – the FOMC went ahead with its first interest rate hike in more than nine years. The move raises the Fed funds target rate to 25 to 50 basis points from 0 to 25 basis points.


Given the mechanics of Fed liftoff were quite different this time than during past monetary policy moves, we thought an early-hours review of how things are going was in order. Despite some money market uncertainty and trepidation that the Fed would be able to really manage to lift the Fed funds rate with a 3.0 trillion plus balance sheet, the early evidence seems to sweep those fears aside.


The theory of Fed liftoff has now become a reality.   Indeed, so far at least, the mechanics of the liftoff appear to have come off better than the Fed could have even imagined. Tacked on to the end of the FOMC statement was an implementation note that spelled out how the Fed planned to move the Fed funds effective rate into its new higher target rate range of 25 to 50 basis points.


On Dec. 17th, the FOMC raised the interest rate it pays on bank excess reserves by a quarter percentage point from 0.25 percent to 0.50 percent.  This puts an effective ceiling on the Fed fund rate or overnight lending rate in the market.


At the same time the FOMC directed the trading desk in New York to conduct open market operations to help maintain the Fed funds rate within the FOMC’s target of 25 to 50 basis points.  Specifically, reverse- repo operations priced at an offering rate of 0.25 percent and term reverse-repo operations.  These reverse repo-operations are expected to set an effective floor on the Fed funds rates, keeping it within the FOMC’s targeted range.


Early evidence suggests the theory is working smoothly in practice. The Effective Fed funds rate was 0.35 percent at 8AM Eastern Time on Thursday and traded somewhat above that rate to 0.38 percent during the trading day.


Importantly, the FOMC directed the Fed’s trading desk in New York to keep rolling over maturing debt on the Fed’s balance sheet, and the FOMC statement mentioned that the Fed will maintain the size of its securities portfolio “until normalization of the level of the federal funds rate is well under way”.  This probably means for at least another year- sometime in 2017.


Borrowing costs are already going up for business loans and credit cards. The three month Libor rate is trading around 59 basis points today, about 25 basis points higher than a month ago.  The Prime Rate also increased on Wednesday to 3.50 percent from 3.25 percent. Many business loans are priced off of Libor and/or the bank Prime Rate.


Wednesday’s action is only the beginning of a Fed tightening cycle that will slowly lift U.S. borrowing costs and eventually consumer deposit rates, over the next several years.  However, this process is expected to remain glacial by historical standards, and we expect only three additional quarter point interest rate moves in 2016.  Probably two additional rate hikes before next year’s Presidential election, and one at the December FOMC meeting just following the November election.  Just as the U.S. economic recovery has been a slog, the Fed’s return to interest rate normalcy will be a marathon.


To learn more, check out this week’s US Outlook Report.

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