What you need to know about the US Federal Reserve’s (the Fed’s) decision to raise interest rates in the United States.

• The US Federal Reserve (the Fed) has finally, and unanimously, started the monetary policy normalisation process by raising the Fed Funds target rate by 25bp to between 0.25% – 0.5%.

• Fed Chair Janet Yellen has noted that while economic growth has been moderate, the labour market has shown “considerable improvement.”

• Fed Chair Yellen also emphasised that further rate hikes will be gradual, with this term used twice in the official statement and repeatedly in the Chair’s press conference.

• The Fed’s ‘dot’ forecasts for the Fed Funds rate have not been altered, with the end 2016 ‘dot’ implying four rate hikes in 2016. (The Federal Open Market Committee (FOMC) participants forecast the Fed Funds rate, which is plotted on a chart known as the ‘dot plot’).

• The Fed’s economic forecasts have been altered only a little. The unemployment rate is now forecast at 4.7% through 2016, 2017 and 2018. Economic growth is forecast at 2.4% in 2016, before moderating to 2.0% by 2018. Underlying inflation is expected to drift higher from 1.6% in 2016, to 1.9% in 2017 and 2.0% in 2018.

US Federal Reserve: feels like the first time

The Federal Open Market Committee (FOMC) of the US Federal Reserve (the Fed) has finally, and unanimously, started the monetary policy normalisation process by announcing a 25 basis point increase in the Fed Funds target range from between 0% – 0.25% to between 0.25% – 0.5%.

The statement accompanying the policy decision highlighted the improvement in the US economy, noting that “there has been considerable improvement in labour market conditions this year.” Overall, however, the Fed notes that “economic activity has been expanding at a moderate pace”, with household and business investment “increasing at solid rates”; housing improving further, but net exports “soft”.

As widely expected, the Fed emphasised (twice) that the pace of further rate hikes will be gradual, stating “the Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the Federal Funds rate” and that “the Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labour market indicators will continue to strengthen.”

The Fed statement also reinforced the ‘data-dependent’ nature of the policy outlook, stating that “the actual path of the Federal Funds rate will depend on the economic outlook as informed by incoming data.”

The outlook for global markets

For global financial markets, 2016 is expected to see further volatility as a result of central bank activity.

While the US Fed, and eventually the Bank of England, is expected to be putting interest rates up through 2016, other major central banks are expected to be easing policy further. This includes Europe, Japan and China.

This central bank policy divergence is vastly different from the policy environment we have seen in global markets since the global financial crisis — where all major central banks were essentially moving monetary policy in the same direction.

So while the US Fed putting interest rates up is a very positive sign for the US economy, it is likely to see an ongoing increase in market volatility through the year ahead.

The ‘dot’ plots

Having made the decision to raise the Fed Funds target range today, the key issue for markets now is the path forward for interest rates and the likely end point. In this regard, the FOMC members ‘dot’ point forecasts are important.

• For the end of 2015 the Fed Funds rate will now trade in the new 0.25% – 0.5% range.
• The end of 2016 median ‘dot’ remains unchanged at 1.4%
• The end of 2017 median ‘dot’ is now at 2.4%, from the September estimate of 2.6%.
• The estimate of the end of 2018 ‘dot’ is also marginally lower at 3.3%, down from 3.4% in the September estimate.
• Further out, the long-term ‘dot’ remains unchanged at 3.5%.

Fed Rate median “dot’ forecast

Source: US Federal Reserve, 16 December 2015

Revised economic forecasts

As per the usual quarterly pattern, the Fed has updated its economic forecasts. The changes to the economic projections are relatively minor.

• On the labour market, the Fed now expects an unemployment rate of 4.7% at year-end 2016, 2017 and 2018 — down slightly from the previous forecast of 4.8%. The longer-run unemployment rate forecast is unchanged at 4.9%.
• For 2016, the Fed now expects GDP growth of 2.4%, up a little from the September forecast of 2.3%. The 2017 growth forecast is unchanged at 2.2%, while the longer run forecast is unchanged at 2.0%.
• The inflation (Core PCE) forecast for 2016 has been revised marginally lower to 1.6% from 1.7%, but across the out-years the forecasts for inflation have all been held steady

Past performance is no indication of future performance. This document has been prepared by Colonial First State Investments Limited ABN 98 002 348 352, AFS Licence 232468 (Colonial First State) based on its understanding of current regulatory requirements and laws as at 17 December 2015. This document is not advice and provides information only. It does not take into account your individual objectives, financial situation or needs. You should read the relevant Product Disclosure Statement available from the product issuer carefully and assess whether the information is appropriate for you and consider talking to a financial adviser before making an investment decision.