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After Fed "liftoff" last year, another rate hike

December 14, 2016

The U.S. Federal Reserve announced a 25-basis-point increase to short-term rates at its December 13–14 meeting, the first one since the "liftoff" last year, and the second time in more than a decade. The move was largely expected given the succession of stronger economic data, specifically in the labor market, and comments from a number of Fed officials prior to the central bank's Federal Open Market Committee meeting. The latest move may add credibility to the Fed's data-dependent framework, something the market had begun to question given that an entire year had passed since the previous rate hike.

"We hope this signifies a continuation of gradual tightening and removal of the extraordinarily accommodative monetary policy put in place after the Global Financial Crisis," said Vanguard Global Chief Economist Joe Davis.

Looking ahead

Looking at next year, we are encouraged by the decision to raise the fed funds rate, and over the course of the next year look forward to continued progress toward normalizing rates.

"We believe the Fed could raise policy rates to 1.5% by the end of 2017, potentially once a quarter," said Davis. "The U.S. economy is strong enough that it no longer warrants short-term interest rates below 1%."

According to our economic outlook, Vanguard believes the federal funds rate is likely to remain below 2% through at least 2018. This is also in line with the Fed's indication that future increases will be gradual.

Consistent hiring in recent years has pushed the unemployment rate down to 4.6% and left the job market with fewer available workers. The tighter labor market is likely to continue in 2017, as firmer signs of inflation, wage growth, and a stronger economy support the case for higher rates.

What will higher rates mean for bonds in my portfolio?

Fed rate increases could well bring some short-term pain to the bond market (bond prices fall as rates rise). It's important to realize that the rate increase is a sign that the Fed believes the U.S. economy is healthy enough to progress with normalizing rates. Policy changes can cause some short-term volatility in the market as investors digest the news, but bonds still play an important role helping to maintain stability in portfolios, particularly during volatile stock market periods.

It's helpful to keep in mind the silver lining—higher rates can benefit long-term investors. The higher cumulative income from reinvested dividends and compound interest can outweigh the front-end volatility from rising rates over the long run.

The investment environment over the next five years is likely to be more challenging than the previous five. Given our economic outlook, we project that expected returns will be modest across all asset classes when compared with the heady returns experienced since the depths of the Global Financial Crisis. That's why, according to Davis, it's more important than ever to keep sight of one of Vanguard's key principles: Maintain discipline.