The Federal Reserve Is About to Raise Interest Rates Again

The Federal Reserve appears set to raise the federal funds rate for the seventh time in the current rate-hike cycle.

In this segment from Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matthew Frankel give a rundown of the potentially market-moving parts of the Fed's statement that investors should watch for.

A full transcript follows the video.

This video was recorded on June 11, 2018.

Michael Douglass: The Fed is widely expected to bump the interest rate, raise the fed funds target to 1.75-2%, which is a 25 basis point hike.

Matt Frankel: This would be the seventh rate hike in the current cycle. Basically, a quick background on what this means, when you hear that the Fed is raising rates, this means the federal funds rate, which has wide implications, as we've already discussed a little bit. Specifically, the prime rate is directly linked to the federal funds rate, so anything that's linked to the prime rate is also going to rise. This includes pretty much every credit card in existence. I think something like 99% of credit cards are directly linked to the federal funds rate. Home equity lines of credit also will rise in tandem with the federal funds rate. And other consumer interest rates, like we mentioned, mortgages, auto loans and such, tend to move in the same direction, although it's not a perfect correlation. The general rule is, the shorter-term the lending instrument is, the better the correlation will be. This is why auto loans tend to move a little bit closer in line with the federal funds rate than, say, mortgages.

But, the real story here isn't about the rate hike. There's over a 90% chance of a rate hike already priced into the market, so it's pretty much a certainty that it's going to happen. The real stories are what else the Fed talks about -- specifically, where do they see interest rates going? One of the big questions is, will there be another one or two interest rate hikes after this year? At the beginning of the year, the big thing was three or four, and this will be two. The Fed's projection, which is known as their dot plot, if you see that in articles after the meeting, should give us a little more color on what to expect the rest of this year and the next few years.

Douglass: Of course, I imagine one of the big questions that will be coming out from the Fed -- I'll be very interested to see what the Fed governors make of a potential trade war, and how they see that impacting things, and how likely they think that is to happen. I think a lot of market-watchers will be really laser-focused on this particular meeting to try to get an understanding of where our central bankers essentially think things are going and what's really going to happen.

Matt, as you and I were talking a bit before the show, the Fed generally paints a pretty rosy picture. Unemployment projections are supposed to be down to 3.6% 2019 to 2020. Does that get impacted? Inflation is supposed to be about 2.1% in 2020. How does that get impacted from here? The Fed very clearly views very gradual ramps up in inflation, down in unemployment, and GDP growth that's in the twos, which is pretty darn good. The question is, what does the current uncertainty, what does the recent bank regulatory reform, what do all these other things, how do those come into this forecast and change it?

Frankel: Right. It's worth noting that one of the big questions here is that, you mentioned the unemployment, they're projecting 3.6% for 2019 and 2020, and only about 2% inflation. That's remarkably low inflation historically for such good unemployment. Generally, when unemployment gets to that level you'll see inflation in the 4-5% range. And, it's also worth mentioning that all those projections you just mentioned were revised up significantly at the last meeting. It'll be interesting to see if the Fed still sees it going in such a rosy direction, or if all of this talk about trade wars and things like that have made them a little more cautious and taking a step back.

Douglass: Yeah. I think that's going to be a big question. Of course, one of the other big issues we'll have to see happening from here is, what's going to happen with the balance sheet runoff, and how is the Fed going to reduce its exposure there?

Frankel: Basically, in the aftermath of the financial crisis, the Fed started buying up treasuries to stimulate the markets, and wound up with a balance sheet of about $4.5 trillion. Recently, not too recently, the Fed has indicated that it was going to start selling these off, unwinding its balance sheet. Most of the Fed directors indicated that it would generally get down to about $2.5 trillion in this round of unwinding. Now, recent reports are indicating that this might end a little sooner and be not quite as deep of an unwinding as we thought, which could be indicating that the Fed isn't going to hike rates quite as much as initially projected over the next few years. So, that's another thing to keep an eye out for, the Fed's balance sheet, and any comments toward that. There's some speculation that they might wait until the August meeting to really talk more about it. But they could surprise the market. There's a big buzz that this is coming this meeting.

Douglass: Yeah. Again, it's one of those things where, when you look at the Fed, what you have to think about is the Fed's viewpoints on what future growth looks like, and then, how risky or how likely, how certain they feel about that growth actually occurring. Future growth is going to happen, the Fed's going to raise rates, just as a general rule. And, they're going to try to, again, get those treasuries off their balance sheet. If there are risks to those outcomes, then the Fed is going to become more conservative in how it approaches those things. So, that's going to be a big thing for us to watch going forward.

Frankel: Just remember, at the end of the day, the Fed's goal is to maintain orderly, non-panicked markets. Pretty much everything they do will be toward that goal. If they see something deviating from what they feel is a normal, healthy market, then expect them to modify something you're doing.

Douglass: Right. And, of course, much as they are experts, the Fed cannot predict the future, nor can the rest of us. Do not take anything that they say, or anything we say, or anything anybody else says, as gospel, because no one really knows for sure what the future is going to bring.