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Fed Stays on Track with Rate Increase

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Fed Chairman Jerome Powell addresses the media in his first press conference since being appointed by President Trump.

Fed to stay on course with rate increases even as economic and inflation projections remain modest.  "Our inflation objective is symmetric."

The U.S. Federal Reserve, the world's largest central bank, raised its short term federal funds rate by a quarter percent yesterday bringing the signature interest rate to 1 3/4%, it's highest level since 2008, the year of the crisis when it dropped from 4.25 to 0.25 (see graph below).  The Fed has projected a rate in the range of 2.1% by the end of the year, which would mean at least two more rate increases.

"This decision marks another step in the ongoing process of gradually scaling back monetary policy accomodation -- a process that has been underway for several years now," Mr. Powell said.  The Fed chair also pointed to an expanding economy, an inflation mark that is moving towards the Fed's 2 percent goal and steady job gains as reasons for the increase.  The decision to raise its benchmark rate was unanimous.

This marks the sixth in a string of quarter-point rate increases that began in December 2015 when the Federal Reserve, then under the leadership of Chairwoman Janet Yellen, finally began to normalize interest rates after eight consecutive years of extraordinarily accomodative monetary policy.  Rates rose three times in 2017, once in 2016 and once in 2015.

While the Fed is trying to stay on a path of normalization, one of its main objectives is clearly to avoid an unecessary slowdown to the economy or a shock to the stock market. "We're trying to take the middle ground, and the committee continues to believe that the middle ground consists of further gradual increases in the federal funds rate," Mr. Powell said.

Market reaction to the Fed's decision was mixed with the Dow Jones Industrial Average closing down 44.96 points to finish at 24,682.  The yield on the benchmark 10-year U.S. Treasury note climbed to 2.901% from 2.881%.  Yields move opposite of price.

However, the yield on junk bonds, a huge beneficiary of low rates over the years, ticked up to 6.246% from 6.172% as measured by the Merrill Lynch High Yield 100 junk bond index.  Meanwhile, the credit spread, the difference in interest rates between the 10-year Treasury note and junk bonds and a key measure of market integrity, ticked up 4.4% to 3.414.

Although the Fed described the economy as expanding, it has projected a modest 2.7 percent increase in GDP for 2018, followed by 2.4 percent next year and 2 percent in 2020.  When asked what it would take to achieve 3 percent GDP on a sustained basis, the Fed chairman replied: "It's hard to say, but that is well above almost all current estimates of potential long-run growth."  He went on to say that productivity and labor-force participation would need to significantly improve.

In the meeting with reporters, Powell pointed to the recently passed tax cuts and possible infrastructure spending as factors that could help the economy.  "Productivity has been very weak," Mr. Powell said in response to a question from a reporter.  "Since the financial crisis, it's averaged only .5 percent a year for the last six years, well below longer run averages." 

The Fed chairman then used a term that his predecessor was loathe to use -- supply-side.  "I think it's important that we have a focus on productivity in this country," Mr. Powell said.  "It's not somethign that we can really do at the Fed, but we're certainly hopeful that there will be supply-side effects from the tax bill."