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Awaiting the Inevitable Interest Rate Hike

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Monday, December 11, 2017

This week, the Federal Reserve Open Market Committee (FOMC) meets for the final time under outgoing Fed Chair Janet Yellen, who will step down from the Fed following a four-year reign as a relatively dovish, yet consistent, head custodian of the U.S. economy. She will be replaced early next year by President Trump’s pick, Jerome “Jay” Powell.

Currently the Fed funds rate is at 1.25%, and with chances just about zero that there won’t be a hike this week, market participants are already pricing the quarter-point hike to 1.5%. This is obviously the highest the Fed funds rate will have reached since the Great Recession caused the rate to be pulled all the way down to 0 (actually 0.25%).

This slow and steady methodology has taken longer than many had anticipated to reach equilibrium, but we are definitely there now: with inflation currently registering at 1.6% — close to the optimum Yellen & Co. had long been seeking of 2% — while unemployment — the other half of the Fed’s dual mandate — came in at an historically low 4.1% just last Friday.

Looking into 2018, however, many analysts expect big changes: the massive tax cut for U.S. businesses and some individuals looks to both lower the unemployment rate further (based on the argument that cutting corporate taxes from 35% to 20% will lead to more job creation) and spike inflation higher (because along with all these new jobs we can also expect higher wage growth, which is a key sign of rising inflation). Meaning that we look to be heading toward sub-4% unemployment, but inflation could surge well above 2% in relatively short order.

Part of the Fed’s job in conducting interest rate changes is to sop up some of this inflation before it gallops out of control, so speculation is rife about how many times the Fed will raise rates in 2018. Obviously, much will pivot on if and when the tax cuts are passed through Congress and implemented into the economy; if it’s before Christmas or right after New Year’s, it’s likely we’ll see a March rate hike, if not sooner. Should things take a little longer, the Powell-led Fed may take a page from the Yellen playbook and await economic evidence of job and inflation growth before moving.

There is also the issue of how much the Fed might raise when it finally decides to, again dependent on the lay of the economic land next year. Should the economy heat up faster than expected, look for speculation involving a half-point rate hike (from 1.5% to 2%) instead of a quarter point. And if this happens, look toward the finance sector — particularly the banks, like Zacks Rank #2 (Buy)-rated Comerica Inc. (CMA - Free Report) , and the insurers, like Zacks Rank #2 firm Prudential (PRU - Free Report) and MetLife (MET - Free Report) .

Mark Vickery
Senior Editor

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