Federal Reserve hikes benchmark interest rate to as much as 2.5%

The U.S. Federal Reserve is raising its key interest rate for the fourth time this year to reflect the U.S. economy's continued strength but signalling that it expects to slow hikes next year.

The quarter-point hike, to a range of 2.25 per cent to 2.5 per cent, lifted the Fed's benchmark rate to its highest point since 2008. The increase will mean higher borrowing costs for many consumers and businesses.

The statement the Fed issued Wednesday after its latest policy meeting said "some" further gradual rate increases are likely. But its updated forecast projects just two rate hikes next year, down from three the Fed had predicted in September.

The new forecast also reduces the long-run level for the Fed's benchmark rate to 2.8 per cent, down from three per cent.

Markets react

U.S. stocks rapidly surrendered an early surge Wednesday afternoon as investors reacted to the announcement. Stocks had been sharply higher before the Fed announced the rate hike. The Dow Jones Industrial Average closed down 351 points at 23,323 after being up as much as 200 points before the rate announcement. That's the lowest close for the Dow in more than a year, stretching back to Nov. 15, 2017.

The Fed has raised rates with steady regularity as the U.S. economy has strengthened. Wednesday's was the Fed's ninth hike since it began gradually tightening credit three years ago.

But a mix of factors — a global slowdown, a U.S.-China trade war, still-mild inflation, stomach-churning drops in stock prices — has led the Fed to consider slowing its rate hikes in 2019 to avoid weakening the economy too much. It's now likely to suit its rate policy to the latest economic data — to become more flexible or, in Fed parlance, "data-dependent."

The Fed has so far managed to telegraph its actions weeks in advance to prepare the financial markets for any shift. But now, the risks of a surprise could rise. Next year, Chairman Jerome Powell will begin holding a news conference after each of the Fed's eight meetings each year, rather than only quarterly. This will allow him to explain any abrupt policy shifts. But it also raises the risk that the Fed will jolt financial markets by catching them off guard.

Economic barometers

Some analysts say the Fed may want to pause in its credit-tightening to assess how the economy fares in the coming months, given the headwinds it faces.

Contributing to this view was a speech Powell gave last month in which he suggested that rates appear to be just below the level the Fed calls "neutral," where they're thought to neither stimulate growth nor impede it. Powell's comment suggested that the Fed might be poised to slow or halt its rate hikes to avoid weakening the economy.

For now, most U.S. economic barometers are still showing strength. The unemployment rate is 3.7 per cent, a 49-year low. The economy is thought to have grown close to three per cent this year, its best performance in more than a decade. Consumers, the main driver of the economy, are spending freely.

After the two rates increases that the Fed now envisions for next year, it foresees one final hike by 2020, which would raise it benchmark rate to 3.1 per cent. By 2021, four Fed officials envision reversing course and actually cutting rates to help stimulate the economy.

By lowering the long-run estimate for its key rate from three per cent to 2.8 per cent, the Fed is signalling that it doesn't need to tighten credit much further to prevent the economy from overheating. Its statement describes the economy as strong. But it did note potential threats by adding language to say it would monitor global developments and assess their impact on the economy.

Growth forecast adjusted lower

In its updated outlook, the Fed lowered its forecast for growth next year to 2.3 per cent from the 2.5 per cent it foresaw three months ago. It predicts two per cent growth in 2020. Those estimates are far below the Trump administration's insistence that its tax cuts would help accelerate annual growth to 3 per cent in coming years.

Given the still-healthy U.S. economy, the Fed would normally keep gradually raising rates to make sure growth didn't overheat and ignite inflation. But this time, the risks to the economy seem to be rising. From China to Europe, major economies are weakening. U.S. President Donald Trump's trade conflict with Beijing could, over time, undermine the world's two largest economies.

There are also fears that the brisk pace of U.S. growth this year reflected something of a sugar high, with the economy artificially pumped up by tax cuts and a boost in government spending. The benefit of that stimulus will likely fade in 2019, slowing growth to a more modest pace. And as U.S. interest rates have risen, loan-sensitive sectors of the economy, from housing to autos, have begun to weaken.

In addition, the Fed has been gradually shrinking the vast portfolio of Treasury and mortgage bonds it built up after the 2008 financial crisis. This process is thought to have had the effect of putting further upward pressure on borrowing rates for consumers and businesses.

Trump attacks

Economists appear unified in the view that whatever the Fed does, it won't be influenced by the attacks Trump has made on the central bank and on Powell personally since the stock market began tumbling this fall. In a highly unusual move for a president, Trump has repeatedly and publicly denounced the Fed's rate increases. At one point, the president called the Fed and its string of rate hikes this year "my biggest threat."

This week, Trump fired off two tweets objecting to a likely rate hike. In one of them, he called it "incredible" that the Fed would consider raising rates again when "the outside world is blowing up around us."

Powell, who was Trump's hand-picked choice to be chairman, has stressed that the Fed will pursue its mandate of managing rates to maximize employment and stabilize prices, regardless of any outside criticism.

The central bank meets next on Jan. 30. Trading in investments known as Federal Reserve futures implies there's about a 27 per cent chance of a hike that day.