Dawn Desjardins is Deputy chief economist at Royal Bank of Canada.
After a couple of false starts earlier this year, U.S. Federal Reserve Board Chair Janet Yellen and the Federal Open Markets Committee – the central bank's policy-setting arm – raised their benchmark interest rate Wednesday for the first time in close to a decade. The announcement of a 25-basis-point increase in the Fed funds target band came exactly seven years to the day after the Fed lowered the rate from 1 per cent to a range of zero to 0.25 per cent. (A basis point is 1/100th of a percentage point.)
The decision was not met with a hue and cry by financial markets, but with stoic understanding that the U.S. economy no longer requires interest rates at the lower bound, or close to zero per cent.
The statement accompanying the Fed's decision confirmed a positive assessment of the U.S. economy's performance given solid gains in consumption and business investment. Critical to taking this step was the reduction in unemployment in the labour market in 2015 and the Fed's confidence that even though inflation currently stands below the 2 per cent goal, the headline rate will meet this objective over the medium term as labour markets tighten further.
With Wednesday's move largely anticipated, more interesting was the FOMC's economic projections, which showed that participants expect the rate increase will have very little impact on the economy, with forecasts of real gross domestic product (GDP) growth in 2016 boosted slightly relative to the September projection and another year of above-potential growth pencilled in for 2017.
The forecasts similarly showed that members expect the U.S. unemployment rate to fall further next year and the inflation rate to gradually rise to 2 per cent. According to the Fed's "dot plot," which shows the FOMC participants' judgments of the appropriate policy rate over time, members anticipate another 100 basis points of rate increases in 2016. This would still leave the Fed funds target band at a historically accommodative band between 125 and 150 basis points. In her news conference, Ms. Yellen reinforced the view that future increases will be gradual and conditional on the economy's performance.
Wednesday's decision and Ms. Yellen's optimism are in keeping with our own read on the U.S. economy. The soft start to 2015 reflected one-off factors that quickly reversed, resulting in domestic demand growing at a solid clip in the second and third quarters. Recent data point to solid consumption and investment activity in the final quarter of the year. We look for 2016 to mark a watershed, with real GDP forecast to expand at a 2.8-per-cent pace, which would be the fastest increase since 2005. Healthy consumer demand, a strengthening housing market and businesses stepping up the pace of investment will more than compensate for another year of net exports acting as a drag on growth.
Even with the Fed forecast to continue to temper monetary policy support in 2016, financial conditions are expected to remain accommodative. The U.S. dollar is likely to strengthen, making imports yet more attractive while curtailing demand for U.S. exports. The strengthening in the economy's momentum will fuel further increases in employment, exerting downward pressure on the unemployment rate and pushing wages up. This upward pressure on wages, combined with a recovery in energy prices, will likely result in the headline inflation rate rising in 2016 – validating the Fed's assumption that inflation will reach the 2-per-cent objective over the medium term.
So, while it has been a long time coming, U.S. interest rates are finally on their way up. In a speech earlier this month, Ms. Yellen said that when the Fed began to normalize interest rates, it would be a testament to her country's economy having recovered from the financial crisis and therefore "a day that I expect we all are looking forward to." Yes, indeed.