The Fed Plays It Cool


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What's going on?

As everyone expected, the US Federal Reserve (“the Fed”) increased its target interest rate on Wednesday (tweet this). However, it struck a cautious tone when forecasting its future actions – and that caused a significant market reaction.

What does this mean?

The US economy seems to have been on a bit of a roll lately: more and more people are getting hired, wages are growing at close to their fastest pace since the 2008 financial crisis and inflation is increasing (which suggests that people are prepared to pay more for things). All of this has encouraged the Fed to gradually raise its target interest rate over the past 15 months.

Remember, higher interest rates typically create a headwind for the economy by making it more expensive to borrow, and thus spend, money. However, one reason for the Fed to raise interest rates now is so that it can lower them again should the economy turn sour.

Why should I care?

For the markets: Investors appeared surprised by the Fed’s cautious tone.

Some investors thought the Fed would say it expected interest rates to rise more quickly in the future. But the Fed didn’t really do that, which seemed to catch the market by surprise. For one, the US dollar dropped by 1% versus other major currencies (why are lower interest rates typically bad for a currency’s value? Click here). Secondly, bonds and stocks jumped up significantly in value. There is a lot at play here, but lower interest rates are typically good for bonds and many types of stocks (click here for more on that).

The bigger picture: Politics is only getting more important for investors.

Many investors are optimistic that new government policies will be positive for the US economy. For example, President Trump has promised lower corporate taxes. But the Fed isn’t (yet) assuming any new proposals will become law. If policies out of Washington lead to higher economic growth and inflation, it seems likely that the Fed will raise interest rates more aggressively later this year and/or next year.

Originally posted as part of the Finimize daily email.

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