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When is a rate rise dovish?

20 December 2018

Last night the Federal Reserve raised rates by 0.25% but has modified its expectation for next year to slow the pace of rate rises. After the September meeting, a December rate rise had seemed to be a near certainty, but expectations had fallen as the rhetoric from the Fed moderated. Before the meeting the probability in markets was just 60%. President Trump has been putting pressure on the Fed not to raise rates any further. The Chairman of the Fed, Jay Powell, made it clear in his press conference that they would be driven by economic data and expectations rather than political pressure.  However they have moderated the expectations for the future path of interest rates. The "dot plot" that shows the expectations of individual governors has moved lower. The median expectation for the long-term rate has come down from 3% to 2.75%. The median expectation for the peak has also moved down and the dispersion now shows more members below the median than above. Therefore, whilst raising rates, the Fed is becoming more dovish on the expected path of rates in the future. The expectations however, were for an even more dovish outcome and markets have reacted badly.

The Standard & Poor's 500 US equity index which had risen by 1.5% ahead of the meeting, fell by 3% after the meeting to end down 1.5%. US ten year treasury yield fell 0.07% to 2.75%. Taking their lead from the US, the Far East and European equity markets have also fallen.

President Trump will no doubt take to Twitter declaring it a mistake, and if the economy slows, will be able to blame the Fed. The reason the Fed has raised rates and expects to continue to raise rates next year, is that they expect the economy to remain strong with low unemployment and inflation close to their target. If they had been more dovish it could have been seen as indicating that they had greater concerns about the economy, making it hard to strike the right balance.

Elsewhere, there has been better news. The threatened US government shut down on Friday has been averted and the EU has approved a revised Italian budget. A month ago if you had said the Fed would moderate the path of interest rates for next year and the Italian budget would be passed, one would have expected a positive reaction. This close to the Christmas break, thin markets and raised expectations of Fed moderation, have pushed markets to react in the opposite fashion.