Fed Hikes by +25 bps, Eradicated Cap for RRP

For the first time since 2006, the Fed raised the target range for the Fed funds rate by +25 bps, to 0.25%-0.5%. The decision was widely expected and was made in unanimous vote. To our, and the market’s, surprise, the Fed removed that cap of the overnight reverse repo (RRP), a tool that allows investors to lend cash in exchange for Treasuries and an instrument that the Fed uses to raise short-term interest rate. FOMC judged that the risks to the outlook for economic activity and the employment market were ‘balanced’, compared with ‘nearly balanced’ as mentioned in previous meetings. The members anticipated inflation to return to 2% over the medium term. The central bank reiterated that it would continue to ‘monitor inflation developments closely’.

The key surprise of Fed’s announcement was eliminated of cap, currently at US$ 300B, of the overnight reverse repo (RRP). According to a statement released by the New York Fed following the meeting, the tool would be “limited only by the value of Treasury securities held outright. While some market participants had anticipated the Fed to lift the size of the program, say, to a double of US$ 600, they had not expected an aggressive total removal. The move suggests the Fed’s determination to control short-term markets and to ensure the rates would actually rise after the rate hike. Note that, the Fed also voted to increase the RRP rate from 0.05% to 0.25%.

At the press conference, Chair Janet Yellen indicated that the decision to hike interest rate this time was a reflection of US economic improvement. As she noted, ‘Fed’s decision today reflects our confidence in the U.S. economy… While things may be uneven across regions of the country and different industrial sectors, we see an economy that is on a path of sustainable improvement’. Moreover, “business investment [outside of the mining and drilling sectors] has posted solid gains’ while weakness in US exports “has been offset by solid expansion of domestic spending’. On the employment market, Yellen indicated there had been ‘substantial improvement in labor market conditions” and the rate hike should be interpreted as a signal that “job market prospects will be good’.

The Fed stressed that the path of rate hike would be gradual and dependent of macroeconomic data and other events. As mentioned in the accompanying statement, the members judged that ‘economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate’. They believed that the policy rate would ‘likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data’. The new dot plot shows that members still expect rates to rise to 1.25-1.5% in 2016, signaling 4 hikes next year. Yet, the members’ median rate forecast is trimmed to 2.4% at the end of 2017, compared with 2.63% in September. The 2018 target was reduced to 3.3% from 3.4%. The longer-term forecast stands at 3.5%.

The staff economic projections, however, showed little change from the previous meeting. Fed officials forecast the economy to expand +2.4% in 2016, up from +2.3% projected in September. Growth in 2017 would then ease to +2.2% in 2017. In the longer run, GDP growth would steady at +2%. On inflation, the median forecast was trimmed to +1.6% for 2016, from +1.7% estimated in September. Inflation is not expected to return to 2% until 2018. On the job market, the members forecast the unemployment rate to be lowered to 4.7% in, from the prior estimate of 4.8%. the longer-run unemployment rate steadies at 4.9%. While the RRP rate serves as the floor of the Fed’s interest rate corridor, the interest on excess reserves (IOER), which was lifted +25 bps to 0.5%, serves as the ceiling.

Fed Hikes by +25 bps, Eradicated Cap for RRP