The United States Federal Reserve has announced a 25-basis-point increase to the federal funds rate – a key driver of prevailing interest rates in the US and other countries. It’s the first such move since the Fed’s long-awaited "liftoff" in December 2015, and only the second rise in more than a decade.
The Fed’s decision was largely expected given the succession of stronger US economic data, specifically in the labour market, and comments from a number of Fed officials prior to the 13–14 December meeting of the central bank’s Federal Open Market Committee. It may add credibility to the Fed’s data-dependent decision-making framework, which global markets had begun to question given that an entire year had passed since the previous rate hike.
"We hope this signifies a continuation of gradual tightening and removal of the extraordinarily accommodative monetary policy put in place after the global financial crisis", said Vanguard Global Chief Economist Joe Davis.
Looking ahead
Vanguard is encouraged by the Fed’s decision, and we look forward to continued progress towards normalising rates over the course of the next year.
"We believe the Fed could raise policy rates to 1.5% by the end of 2017, potentially once a quarter", said Mr Davis. "The US economy is strong enough that it no longer warrants short-term interest rates below 1%".
As noted in Vanguard’s 2017 global economic and market outlook, we believe the federal funds rate is likely to remain below 2% through at least 2018. This is also in line with the Fed’s indication that future increases will be gradual.
Improved hiring in recent years has pushed the US unemployment rate down to 4.6% and left the job market with fewer available workers. The tighter labour market is likely to continue in 2017, with positive signs of inflation, wage growth, and stronger economic performance supporting the case for higher rates.
What will higher rates mean for bonds?
Fed rate increases could well bring some short-term volatility to the global bond market, as bond prices fall when rates rise. It’s important to realise that the rate increase is a sign that the Fed believes the US economy is healthy enough to progress with normalising rates. Policy changes can cause short-term turbulence as investors assess the news, but bonds still play an important role helping maintain stability in portfolios, particularly during volatile stock market periods.
It’s helpful to keep in mind another piece of good news: Higher interest rates can benefit long-term investors. This is because the higher cumulative income from reinvested dividends and compounded interest can, over the long run, outweigh losses resulting from initial volatility caused by rising rates.
The investment environment over the next five years is likely to be more challenging than that of the previous five. Given Vanguard’s economic outlook, we project that expected returns will be modest across all asset classes when compared with the strong returns experienced since the depths of the global financial crisis.
That’s why, according to Mr Davis, it’s important for investors to adhere to one of Vanguard’s principles for investing success: Maintain perspective and long-term discipline, which can help one stay committed to a long-term investment program through periods of uncertainty.
