The Fed Continues Its Tightening Campaign
The Federal Open Market Committee (FOMC, or Fed) raised the target for the federal funds rate by 0.25 percentage point to a range of 2.25 to 2.50 percent at its December 2018 meeting, in line with market expectations. The Fed also indicated that it is likely to raise interest rates another 0.50 percentage point in 2019, down 0.25 percentage point from the median of its previous projections in September. Overall, the decision was a finely balanced one, with good arguments for and against raising rates at this meeting. It seems likely that decisions on future rate hikes will remain close calls well into next year.
Market participants overwhelmingly expected the Fed to mark down its projection of future interest rate hikes, but the markdown was on the small side of expectations. Prior to the meeting, financial journalists expected a lower path for future interest rate increases because of worries about foreign growth and trade tensions, falling stock prices, a flattening yield curve, and presidential jawboning against interest rate hikes. However, the language of the FOMC statement suggests that the Fed is confident that the economy is strong enough to justify at least one or two further rate hikes. The main reason to raise rates now despite contained inflation is that policy affects the economy with a lag, and many models of the economy suggest that the current low unemployment rate will gradually push up inflation.
The Fed made no changes to the pace at which it will allow longer-term assets to run off its balance sheet, despite the earlier tweet by President Trump suggesting that it slow the pace of reduction of the balance sheet. However, the minutes of the November FOMC meeting that were released late last month suggest that the Fed is likely to stop shrinking its balance sheet sooner than many had expected, which may have contributed to the recent decline in long-term interest rates. As I discussed in a 2014 policy brief with Brian Sack, there are many benefits and few costs from keeping a large Fed balance sheet.
In a little-noticed step, the Fed further narrowed the spread between its primary policy tools by raising the rate of interest on bank reserves only 0.20 percentage point while raising the rate of interest on overnight reverse repurchase agreements by 0.25 percentage point. This adjustment is a response to the gradual rise in the federal funds rate relative to the rate of interest on reserves in recent months. It was presaged in the minutes of the November FOMC meeting. As discussed in a blog post on that meeting, a narrower spread makes monetary policy more effective while saving taxpayers money.