Investors began the past week in a general malaise, with high expectations that the Federal Reserve would raise interest rates following its Federal Open Market Committee meeting on Wednesday, but with uncertainty about how both bond and stock markets would react to the news. In hindsight, the Fed pulled off something that would have made Houdini proud, not only raising the benchmark federal-funds rate by a quarter percentage point to the 0.75 percent to 1.0 percent range, and projecting two more rate increases later this year, but making investors feel good about it as well.
The Fed meeting is more than just a potential rate change announcement, it’s also an opportunity for economists and investors to learn the Federal Reserve’s opinion of the U.S. economy, along with its forecast for economic growth and inflation in the coming year.
In a news conference following the FOMC meeting, Fed Chairwoman Janet Yellen said, “The simple message is the economy’s doing well.” She went on to say that although the Fed had not changed its forecast for economic growth, unemployment or inflation, it expected further improvement. The central bank also reminded investors that its goal of 2.0 percent inflation “Is not a ceiling on inflation. It’s a target.” It also expects inflation will run above and below that mark from time to time.
Yellen also said, “We have confidence in the robustness of the economy and its resilience to shocks.”
Some are calling the Fed’s deliberate trajectory for higher rates later this year, and into next year, a new phase for the Federal Reserve. At the same time, this new phase comes with some challenges, such as keeping inflation under control while not stalling out the growth plans of President Donald Trump, who has hopes of boosting the economy to levels not seen for over a decade.
Up until last week’s FOMC announcement, the stock market had been experiencing a subtle erosion below the surface, as shares of smaller companies underperformed larger ones, like those found in the Standard & Poor’s 500 index, over the past month. This type of behavior is indicative of a lack of liquidity in the stock market, or in other words less money sloshing around as investors hold more cash. However, by the end of the trading day on Wednesday, the stock market had experienced a significant rebound, led by smaller companies. An indication that investors were feeling more comfortable with taking risk.
Heading into the FOMC meeting, the bond market’s apprehension was not so subtle, as bond prices fell and interest rates rose in anticipation of the rate adjustment. These concerns seemed justified, as investors recalled the two-day drop in bond prices following the rate increase just three months ago, in December. To the surprise of many, like the stock market, bonds also got a boost from the Fed announcement, with high quality and low quality bonds alike experiencing the largest one day gains since the middle of last year.
Most importantly, the market’s reaction to the rate increase this week is an indication that investors believe the financial conditions exist for the Fed to continue with its two additional rate hikes later this year, without hurting the economy and scaring markets.