What the Fed’s first hike in three years means for investors
- The Federal Reserve raised the fed funds target range by 25 basis points, or 0.25%, to 3.75%-4.00%, as widely expected.
- Policymakers expect one more rate hike this year, but they remain divided over whether further tightening will be needed in 2027.
- Markets initially interpreted the Fed’s message as modestly more hawkish than expected. U.S. equities declined and bond yields rose following the announcement, though stocks later rebounded.
- We believe equity markets can continue to perform well in a higher-yield environment, particularly if economic growth remains resilient and corporate earnings continue to rise at a solid double-digit pace.
- Higher short-term bond yields have widened their advantage over cash. This may provide an opportunity to generate more income on excess cash while taking on only modest additional interest-rate risk.
Fed hikes and shifts modestly more hawkish
As widely expected, the Federal Reserve raised the fed funds target range to 3.75%-4.00%, marking its first rate hike in three years. Because the decision was largely priced into markets, investors focused more closely on the Fed’s updated economic projections and Chair Kevin Warsh’s tone in the press conference.
The updated projections pointed to a more inflation-focused Fed. Policymakers raised their inflation forecasts and penciled in another expected rate hike before year-end. Beyond this year, however, the outlook is less settled. Eight of the 18 officials projected one more rate increase in 2027, while the remaining respondents expect no change or a cut. This distribution highlights the lack of consensus on whether further tightening will be needed next year.
The longer-run projection for the fed funds rate also moved modestly higher. This suggests that policymakers are gradually raising their estimate of a neutral policy rate, which neither stimulates nor restrains the economy. If correct, this would imply that current monetary policy may be less restrictive and interest rates may ultimately settle slightly higher than previously thought.
Chair Warsh reinforced the modestly hawkish message by emphasizing persistent underlying inflation pressures. His characterization of the rate increase as “removing a dose of policy accommodation” was particularly notable. In our view, the comment suggests that he does not yet view current policy as meaningfully restrictive and may therefore see room for additional rate increases if inflation remains elevated.
Overall, we believe that the Fed is recalibrating policy to return inflation toward target more quickly. Gradual and measured adjustments amid resilient, steady growth should be less disruptive to markets than rapid tightening intended to restrain an overheating economy.
Economic and labour-market resilience give the Fed room to focus on inflation
The Fed’s updated projections also reflected a somewhat stronger economic backdrop. Policymakers raised their near-term growth outlook, which remains above its estimated longer-term trend, and upgraded their assessment of the labour market. Together, these revisions suggest that policymakers believe the economy can absorb somewhat tighter monetary policy without a material deterioration in employment.
Markets are pricing in a faster pace of tightening by the Bank of Canada than by the Fed, shown below:
