By: Dividend Sensei
The Federal Reserve is the most powerful central bank on earth, and its decisions about interest rates have wide ranging ramifications for global capital markets, the economy, and ultimately the stock market. So let’s take a look at the three most important things investors need to know about the last Fed meeting, the future of interest rates, and most importantly how it will effect your portfolio.
Fed’s Forecast For Economy
The most important thing to know about the Federal Reserve’s Open Market Committee or FOMC (which sets US monetary policy), is its dual mandate. That would be to minimize unemployment (strong economy) while maintaining stable prices (core inflation of 2.0% over the long-term). The Fed uses various models in determining where to set its Federal Reserve Funds Rate or FFR. That’s the overnight lending rates that banks charge each other for overnight loans. Banks index their prime rate, (from which short-term and variable lending rates are set) to the FFR. Thus when the FFR rises, so do consumer borrowing costs. This is why the Fed uses the FFR to try to stabilize the economy, by either slowing or accelerating growth by indirectly affecting consumer spending which makes up about 65% to 70% of US GDP.
Under current Fed Chairman Jerome Powell, the Fed has stated it’s being driven by the data, specifically the current and expected growth rate in GDP and inflation. Thus to understand where the FFR is likely to go we need to know where the Fed thinks where the economy, inflation, and unemployment are headed.
The Fed’s latest estimate of US GDP growth showed an increase in 2018 and 2019’s expected growth rates, from 2.8% and 2.4%, respectively, to 3.1% and 2.5%, respectively. 3.1% economic growth (which we’re on track to hit this year from the latest data), would be the fastest full year growth since 2005.
However, the Fed expects growth to slow in 2019 and 2020 as the stimulus effects of tax cuts and $300 billion in greater government spending wear off. By 2021 the FOMC expects growth to be back to its long-term steady state level of 1.8%. The Fed expects this stronger short-term growth to lower unemployment to 3.6% (from 3.9% today) by the end of the year, and bottom at 3.5% in 2019 where it will remain in 2020. Because the Fed estimates the natural rate of unemployment (the lowest level that doesn’t increase inflation via stronger wage growth) to be 4.5% the Fed thinks that its key inflation metric, Core PCE, will hit 2.1% in 2019 and remain there through 2021. Today core PCE is at 2.0%, precisely the Fed’s target long-term rate, and has remained stable at this level for four straight months.
So what does this somewhat disappointing long-term economic forecast mean for interest rates?