The Federal Reserve is not as hawkish as it might appear

December 20, 2016

As expected, the U.S. Federal Reserve (Fed) raised interest rates by 0.25 of a percentage point at its December 2016 meeting. However, it surprised many observers by lifting its forecast for the number of rate hikes it expects in 2017 from two to three.1

The Fed's announcement led to a surge of notes into my email inbox with headlines declaring, “Fed turns hawkish.” We must admit to being a little confused, as we just don't see the basis for the notion that the Fed has suddenly become intent on aggressively rolling back accommodative monetary policies. Presumably, this assertion stems from the Fed's decision to lift rates and from its expectations for three rate increases in 2017.

From our perspective, just about everything else that Fed Chair Janet Yellen communicated in the Fed's statement and in her postmeeting press conference was dovish. Stocks seem to be experiencing a bout of Trumphoria-euphoria based on assumed policies that President-Elect Donald Trump will implement when he takes office2—and in our view, the markets have gotten too far out over their skis. Inflation, economic growth, and interest rates are likely to come in lower than investors seem to currently assume.

Still in the new normal

Despite the reality of a rate hike and the prospect of three increases next year, the Fed's own forecasts reinforce the idea that the new normal—a period of unusually sluggish growth and accommodative monetary policies—is not yet over. Relative to expectations that the Fed issued at its September 2016 meeting, GDP forecasts hardly changed in December, as the Fed continues to expect growth will hover around 2.0% over the next three years.1 Its forecast for long-run GDP growth was 1.8%, unchanged from the outlook it issued in September, and its forecast for core personal consumption inflation remained unchanged as well. The Fed clearly does not think that the election of Mr. Trump will have a huge impact on GDP growth or inflation.

In our view, growth and inflation are unlikely to rise to the degree that the market seems to expect. Even if Mr. Trump manages to push through some of the fiscal stimulus measures that he has proposed, some of them, infrastructure spending in particular, will not feed into the real economy until 2018 or 2019. While some fiscal stimulus and trade tariffs could cause U.S. core inflation to accelerate mildly, this change is likely to be offset by strengthening of the U.S. dollar, which would cause the United States to continue to import deflationary pressures. Furthermore, a lack of robust wage growth could help offset rising inflation.

The Fed's expectations on rates

Much of the attention in the wake of the Fed's December meeting focused on the Federal Open Market Committee's (FOMC) dot plot—a grid representing the range of opinion among FOMC members on the rate outlook—shifting upward to anticipate three hikes next year instead of two.3 For starters, we should not take the dot plots as gospel. Don't forget, after all, that the FOMC forecast four rate hikes for 2016 year compared with the measly one that we eventually got.1 Furthermore, if we exclude the rate expectations of the FOMC's nonvoting members, the forecast for rate hikes in 2017 merely increases from 2.5 to 3.0. Additionally, the Fed's long-run interest-rate forecast is at 3%, a level consistent with the lower-for-longer thesis about an extended period of sluggish economic growth.

Despite December's rate hike, Fed still sees a slow climb ahead

Fog of uncertainty

Looking beyond the numbers, Ms. Yellen's postmeeting rhetoric was extremely dovish. In our view, she bent over backward to highlight that the shift from two to three expected rate hikes in 2017 hardly represents a policy shift at all; rather, she suggested the change reflected only a few FOMC members changing their stances. Ms. Yellen also highlighted that the Fed, like the rest of us, is “operating in a fog of uncertainty.”1 It is incredibly difficult to guess which policies Mr. Trump will pursue as president, which he will be able to implement, and when those implemented policies might feed through into the real economy.

Yellen comments on growth

Ms. Yellen did make two interesting statements about the economy. First, she said that the U.S. economy does not need fiscal stimulus in order to achieve full employment.1 She attempted to shroud this comment in diplomatic language, insisting that she is not pretending to offer policy advice to President-Elect Trump. However, her meaning was clear: Not all fiscal stimulus is created equal, and there is little point in spending unwisely, as this could give us accelerating inflation.

Lower for longer

We disagree entirely with the notion that the Fed has become more hawkish. Instead, the central bank seems to agree with us that we are unlikely to see the kind of acceleration in GDP growth and inflation that investors subject to Trumphoria seem to be expecting. We think the markets are perhaps channeling some of the irrational exuberance that former Fed Chair Alan Greenspan once warned against. Therefore, our belief that we remain in a low growth, low inflation, low rate environment remains intact. Growth and inflation might get a slight bump from fiscal stimulus, but this will only help on the margins and is unlikely to shift potential growth significantly.



1 U.S. Federal Reserve, 12/14/16.

2 “Stock markets after the American election,” The Economist, 11/26/16.

3 “Fed scales back forecasts for rate rises amid global risks,” Financial Times, 3/16/16.

Important disclosures

Core personal consumption inflation is an inflation measure that tracks changes in prices of goods and services purchased by consumers throughout the economy, excluding temporary price volatility resulting from goods that often exhibit rapid or seasonal swings in prices, such as energy and food.

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