Rates Rise as Fed Sticks to Strategy

By Victor Zhang - September 26, 2018

Short-term interest rates moved closer to their historical average today, as the Federal Reserve (the Fed) raised the federal funds rate target 25 basis points. The Fed's latest action pushed the benchmark lending rate to a range of 2.00 percent to 2.25 percent, approximately one percentage point shy of the 30-year average of 3.20 percent.

Today's rate increase marks the Fed's third increase this year. It also denotes the eighth tightening move since the central bank began the process of "normalizing" interest rates. When the Fed launched its latest rate-hike strategy in December 2015, the federal funds rate had been near zero for seven years.

Improving U.S. economic growth, a strengthening jobs market, and gradually rising inflation have kept the Fed in tightening mode for nearly three years. We expect this pattern to continue with the Fed raising rates one more time before year-end, most likely in December.

Inflation Hits Target

Inflation remains key to the Fed's rate-hike decisions going forward, and the central bank appears confident that core inflation (as measured by core personal consumptions expenditures, or PCE) will remain within a range of 2.0 percent to 2.3 percent over the medium term. Core PCE, the Fed's preferred inflation gauge, has been on a gradual upward trend for more than a year. The price index increased at a year-over-year rate of 2.0 percent in July, up from 1.9 percent in June and its recent low of 1.3 percent in August 2017. We continue to believe the combination of solid U.S. economic growth, robust corporate profits and spending, and moderate wage growth will lead to higher inflation, potentially pushing core PCE higher than the Fed's 2 percent target.

Meanwhile, we expect the U.S. economy to continue expanding at a solid and sustainable pace, supported in part by the effects of federal tax and regulatory reforms. We believe these influences, combined with continued labor market gains, suggest gross domestic product (GDP) growth may reach 3 percent (annualized) this year.

Unrest Abroad Clouds Otherwise Upbeat Outlook

In its latest economic assessment, the central bank foresees stronger economic growth and an improving jobs market. Fed officials lifted their economic growth outlook for 2018 to 3.1 percent, up from 2.8 percent in June. Policymakers forecast growth slowing to 2.5 percent in 2019, while their long-term growth expectations remained unchanged at 1.8 percent.

The Fed's year-end unemployment forecast inched higher, from 3.6 percent to 3.7 percent. But, today's forecasted rate still remains lower than the Fed's estimates of long-run unemployment, which range from 4.0 percent to 4.6 percent. This outlook suggests the Fed expects the labor market to exceed the Fed's long-standing guidelines for "full employment." If these expectations prove correct, strength in the jobs market likely will trigger rising wages, which eventually would create inflationary pressures.

Against this potential backdrop, most Fed officials still expect to lift rates at least three times in 2019. Such a scenario would push the federal funds rate to 2.75 percent to 3.00 percent by year-end 2019. This range represents what the Fed currently deems "neutral," a rate that neither sparks nor slows economic growth. However, the "neutral" rate changes frequently and is contingent on growth, employment, and inflation trends.

Financial turbulence outside the U.S., particularly in emerging markets, is another key factor influencing the Fed's outlook. A stronger U.S. dollar could lead to additional unrest in emerging markets, pressuring global economic growth. Similarly, tariffs and ongoing trade tensions between the U.S. and China have the potential to slow global growth, potentially throwing a wrench in the Fed's tightening strategy.

Treasury Yields Remain Rangebound

Against a backdrop of improving economic growth and higher inflation, U.S. Treasury yields have gradually increased this year. Our three-month outlook calls for the 10-year Treasury yield to trade in a range of 2.90 percent to 3.25 percent and the two-year Treasury yield to remain in a range of 2.80 percent to 3.00 percent.

We continue to expect rates to rise gradually overall, but we note upside surprises in inflation data could put additional pressure on yields. In addition, as more central banks join the Fed in normalizing rates, yields could move higher. Also, we remain mindful of potential geopolitical risks, such as global trade disputes and political and economic uncertainty in Turkey and Argentina, which could push yields lower.

Victor Zhang
Victor Zhang
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      Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.