It's a big year for the Federal Reserve. Here's what to expect.
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According to the futures market, investors believe an increase in the current 0.75 percent federal funds target rate on March 15 is a sure bet. A couple weeks ago, investors saw a rate increase as a 50-50 proposition. But members of the Federal Reserve have made it abundantly clear that economic data supports a rate hike this month.

On Wednesday, the Fed’s message will be more than just about the next 0.25 percentage point increase in rates. The central bank is transitioning to a more aggressive path of raising rates. At a minimum, investors should prepare for a quarter point increase every other meeting until federal funds target rate reaches at least 2 percent. That equates to four rate increases in 2017 and at least one more in early 2018 near the time when Janet Yellen’s term as head of the central bank expires.

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With the unemployment rate at 4.8 percent, unemployment claims running at a 40-year low and inflation expectations finally surpassing 2 percent, the Fed has achieved its dual mandate of full employment and stable prices. The future looks brighter as well, with business and consumer confidence spiking higher. As a result, the Fed may fall “behind the curve” on inflation and need to move more quickly to keep inflation contained.

 

There is a growing consensus that this week’s rate increase is already built into the stock market, which can be volatile even on days when the Fed does exactly as expected. While the bond market does a fine job in building in the current rate increase, until the Fed’s official announcement occurs, it’s impossible to have complete certainty about what to expect next. Financial markets will immediately move to anticipate the next Fed move based on the message that accompanies the rate increase. As such, it will be natural for yields to be repeatedly adjusting higher throughout 2017.

More significant than the rate increases will be another transition coming sooner than expected: reducing the Fed’s $4 plus trillion balance sheet of mortgage and Treasury bonds — bonds paid for with money created out of thin air with a few simple keystrokes. $2 trillion worth of that money sits idly as the banking industry’s excess reserves in the sense that it isn’t being lent to people and businesses to be put to a productive economic purpose. It does, however, earn interest for the banks. The central bank has decided that the U.S. government will pay banks a rate at the upper range of the federal funds rate of 0.75 percent.

The Fed believes that if it didn’t keep raising the rate on excess reserves that interest rates would never go up, regardless of where they put their target for the federal funds rate. The federal funds rate represents the rate at which banks charge each other to borrow money overnight. But with an excess of $2 trillion sloshing around in the banking system, the natural laws of supply and demand would push the borrowing rate toward zero.

Since the Fed is paying banks interest, however, no one lends their excess cash out at rate below the government guaranteed rate. The Fed believes it must to do this to force actual short-term rates to match their stated target rate. Of course, the unintended consequence of providing the highest government guaranteed risk-free rate in the country to banks is that there is less incentive for them to take a risk on loans.

The result is this thorny issue of non-elected Fed officials imposing a de-facto tax on American people and businesses, and perversely incentivizing banks to hoard cash rather than to lend it to the very people and businesses being forced to incur the cost. The reverse Robin Hood nature of this arrangement will become increasingly unpopular as rates rise. Interest banks earn on excess reserves currently costs Americans $15 billion annually and increases $5 billion with each additional quarter percent increase.

Considering a less than Fed-friendly President Trump and Republican-controlled Congress, pressure will build to change course and begin reducing the size of the excess reserves, thereby reducing interest expense while also allowing the overnight lending rate to once again naturally approach the federal funds target rate. The only mechanism the Fed has to reduce the reserves is to sell bonds from their balance sheet.

As President Trump fills the two vacant Fed governor positions and begins focusing on Yellen’s replacement, pay particular attention to comments and opinions offered on what to do about excess reserves and the Fed’s balance sheet. Will the new nominees favor letting bonds simply mature or will they pursue an active selling program? Either path likely pushes yields even higher well before a final decision is made as investors begin to anticipate this Fed transition towards normalized policy.

Bryce Doty is a senior portfolio manager of taxable fixed income portfolios for Sit Investment Associates, an investment management firm based in Minneapolis.


The views expressed by contributors are their own and are not the views of The Hill.