Fed stays the course on rates as outlook improves

The Federal Reserve signalled it remains on course for further increases in short-term interest rates this year as inflation heads back towards target, even as it avoided giving strong indications on the timing of the next move.

The US central bank’s Federal Open Market Committee left the federal funds target range at 0.5 per cent to 0.75 per cent in a unanimous decision, following a quarter-point increase at the prior meeting in December.

The unchanged move was as expected by markets and analysts. In its post-meeting statement the US central bank flagged up improvements in consumer and business sentiment and said it expected inflation to rise to its 2 per cent target as it makes further, gradual adjustments to interest rates.

Fed chair Janet Yellen said in January that a “nasty surprise” could be lurking around the corner if the central bank waits too long before lifting rates. The Fed increased rates only twice in the past two years, but its most recent set of forecasts, delivered in December, suggests it will step up the pace of increases in the coming years.

The key uncertainty hanging over central bank policy is the outcome of Republican talks over cutting taxes and boosting infrastructure. Tax plans advanced by Donald Trump during the election would add around $7.2tn to the national debt over a decade, whereas House Republicans’ plans would lift debt by at least $3tn, according to the Tax Policy Center.

If there is indeed a big budgetary loosening in prospect the Fed would probably feel compelled to accelerate the speed at which it is tightening policy as it seeks to keep inflation on track. The central bank made no direct reference to possible budget changes in its statement, reiterating that the risks to outlook appear “roughly balanced”.

But the minutes to its last meeting, in December, suggested a number of policymakers are already building in assumptions of some sort of fiscal change, as are staff at the Federal Reserve Board.

Many economists expect the central bank to hold fire before lifting rates again in June, but if the uncertainty surrounding fiscal policy is dispelled soon and economic data continue to strengthen, it is possible that the US central bank could move before then. The next two US rate decisions will come on March 15 and May 3.

The Fed’s assessment of the economy on Wednesday stuck closely to its previous language, noting that the jobs market had continued to strengthen and that the economy was expanding at a “moderate pace”.

While it referenced low market-based inflation expectations, the FOMC’s statement sounded relatively optimistic about the inflation prospects, saying that with gradual rate rises it expected that price growth “will rise to 2 per cent over the medium term”. It dropped prior language that tied inflation improvements directly to an easing in the impact of low import and energy prices as well as jobs growth.

Ms Yellen last month suggested that a “few” rate increases per year could be on the cards between now and 2019. The fact that rate setters have in recent weeks started talking about how to reduce the size of the Fed’s balance sheet, another means of tightening policy, also sends a hawkish signal about 2017.

The statement on Wednesday did not contain any new language on the outlook for the Fed’s balance sheet, but minutes of the meeting released later in February could record a discussion on the topic.