Why Is the Fed So Confident in the American Economy?

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The Fed is hiking interest rates in response to indicators of a healthy American economy.

The Fed decided to raise interest rates to a target rate of 1.00% – 1.25% in its June meeting. The Fed changes its target interest rate based on economic data, and this practice is one of the many tools it uses to keep the economy in check.

When the economy is growing and corporations are spending more money, the Fed can raise interest rates to keep the economy from overheating. Based on its most recent rate hike, totaling two increases in 2017, the Fed has a positive outlook toward the American economy and its growth.

There are many reasons why this rate increase was 75% likely to happen, based on Fed funds futures in the weeks leading to the rate increase. The April jobs report was phenomenal as 211,000 jobs were created versus the 185,000 jobs that were expected. The economy bounced back from its largely disappointing numbers in March, where payroll job growth fell very short from expectations. Inflation floated predominately above the Fed’s target rate of 2% for the majority of 2017, despite an inflation rate of only 1.89% in May. The Fed’s target inflation rate is 2%, where inflation too high or too low can bring large risks to the market.

In May, unemployment rate decreased to 4.3%, and the underemployment rate also fell. While some other data points counteract a move for interest rates, including a contracting labor force in recent months, and a weaker job growth posting in May (although consistent with past trends), the Fed is planning to stick to its 3 interest rate hikes per year.

The reason for its expedited schedule is due to a fear of the zero-bound, where the interest rate cannot fall below 0%. In the event of another 2008-esque crisis, the Fed would not be able to kickstart a deteriorating market if its interest rate environment is so low. To provide room for quantitative easing for safety measures, the Fed is inclined to move away from its longstanding 0% interest rate environment that existed from 2009 to December 2015.

An interest rate hike largely benefits banks, which can have a greater opportunity for profitability in its fixed income portfolios. This is due to an increase in the yield for its short-term lending, as dictated by the Federal Funds rate. The Fed’s interest rate hike can in turn, boost the banking sector’s corporate earnings, and has already been reflected in the pricing of the S&P Financials ETF (NYSE: XLF). Also contributing to the XLF price increase is the overhauling of Dodd-Frank and the easing of bank stress tests.

The Fed’s move this past week to increase interest rates was well-timed, as the economy has been posting numbers that show steady, modest growth. It also gives an opportunity to raise it again in December, if job reports show up just as strong as it has in recent months.

While yields of fixed income have been predominately low, the climbing yields on 2-year treasury bonds indicate positive investor outlook toward the U.S economy. In addition, lower bond yield spreads between the 2-year treasury, and the 10-year treasury indicate that investors foresee short-term economic growth and upside potential in equities. Since bond yields increase as prices decrease, the upside potential that exists for U.S equities have left 2-year treasury bonds on a portfolio’s sidelines.

As the economy continues to grow and the market continues to trade on a pro-business agenda, the Fed has plans to raise interest rates for the upcoming years.

Aaron Choi is a student at New York University's Stern School of Business.

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