After much anticipation, the Federal Reserve finally announced a rate hike of 25 basis points this last week. The 2016 year now ends with just one rate hike (the last being in December 2015) as opposed to the initially predicted three to four to start the year by many economists. As this tumultuous year finishes, we can look forward to seeing what path the Fed is likely to take next year.
We have mentioned before that it is mostly a given at this point that rates will increase going forward. Rates have been at a historic low for a significant portion of the past decade and it is very natural for rates to increase at this point in an economic cycle. What has been unique is how small and how slow the increases have been. As the chart illustrates below, movements in interest rates have historically been much quicker and in larger increments than what we are currently experiencing.
Current indicators suggest that we will not increase rates like we have historically. However, it is becoming widely anticipated that there could be upwards of three increases next year as opposed to the previously predicted two. While still slower than historical averages, we have been arguing for a while now that the pace is one of the most important factors to consider in the economy.
The good news is that the change in pace is due to a strengthening economy. Unemployment is below historical averages and wage pressure is starting to show up around the country. Inflation is starting to creep up from their dangerously low levels and this allows the Fed to begin bringing rates to a more stable level going forward.
Even with the slightly increased pace, at this point, the change in rates will have a mostly muted effect on the markets. The markets largely had anticipated this move and had already moved in the preceding months. The announcement has slowed down the increase in the stock market as it digests the changes and heads into the holiday season. The three rate increases as opposed to the predicted two are still far slower than historical averages and will give most bonds plenty of time to pay enough income to overcome changes in their prices and still have positive returns overall. While the new path is one to closely monitor, the pace is still within reason and warrants a cautious and patient approach to the new year.