Fed Raises Rates, Sets Out Plan to Shrink Asset Holdings Beginning This Year -- 3rd Update

The Federal Reserve said it would raise short-term interest rates and spelled out in greater detail its plans to start slowly shrinking its $4.5 trillion portfolio of bonds and other assets this year.

The moves on Wednesday mark the latest test of the economy's ability to grow on its own as the central bank dials back the unprecedented stimulus measures it unleashed through successive bursts of bond purchases after the 2008 financial crisis.

"The economy is doing very well, is showing resilience," said Fed Chairwoman Janet Yellen at a news conference following the Fed's two-day policy meeting.

The Fed said it would increase its benchmark federal-funds rate on Thursday by a quarter percentage point to a range between 1% and 1.25% and penciled in one more increase later this year if the economy performs in line with its forecast.

Together with the decision to raise interest rates, the balance-sheet plans show confidence in the economic expansion, which has been unspectacular but is also the third-longest on record.

"We should want the Fed to raise rates because it signals something good about the underlying economy," said Tobias Levkovich, chief U.S. equity strategist at Citigroup. "When it gets overheated and the Fed has to cut if off, that's when you get worried."

Markets were little changed after the widely expected moves. The Dow Jones Industrial Average rose 46.09 points, or 0.2%, to a fresh high of 21374.56. The S&P 500 fell 2.43 points, or 0.1%, to 2437.92.

Wednesday's decisions mark a new chapter for the Fed and Ms. Yellen, whose tenure has been defined by meticulous plans to slowly drain reservoirs of stimulus that she and other Fed leaders forcefully advocated in response to the financial crisis that deepened the 2007-09 recession.

Ms. Yellen's tenure as Fed chairwoman began in early 2014, as the Fed began to slow its purchases of Treasury and mortgage securities, the conclusion of the latest -- and broadest -- effort to spur household and business investment by pushing down long-term interest rates.

The Fed stopped adding to its holdings, also known as its balance sheet, in October 2014, but it has continued to reinvest the proceeds of maturing assets to maintain the portfolio's size. Since then, central bankers in Europe and Japan have ramped up similar bond-buying experiments.

"The Fed has done a tremendous job helping the economy grind its way out of an extremely deep and disruptive recession," said Michael Gapen, chief U.S. economist at Barclays and a former Fed economist.

He added: "It generally operated alone and received a lot of criticism for doing what Congress asked it to do."

Plans revealed by the Fed on Wednesday would start reducing the central bank's holdings gradually by allowing a small amount of net maturities every month. It would start by allowing up to $6 billion in Treasury securities and $4 billion in mortgage bonds to roll off without reinvestment, and let those amounts rise each quarter, essentially setting a speed limit for the wind-down.

The limits would ultimately rise to a maximum of $30 billion a month for Treasurys and $20 billion a month for mortgage-backed securities.

Ms. Yellen said if the economy performed in line with the central bank's forecasts, the Fed could set those plans into motion "relatively soon," which market strategists believe could mean September or October.

Officials have taken pains to communicate their strategy in advance to avoid a rerun of the 2013 "taper tantrum," when investor concerns over the Fed's decision to slow down asset purchases triggered market turmoil, including a sharp increase in Treasury yields and capital outflows from emerging markets.

"The plan is one that is conscientiously intended to avoid creating market strains and to allow the market to adjust to a very gradual and predictable plan," Ms. Yellen said at a news conference Wednesday.

Allowing some of the holdings to mature without reinvestment could push up long-term rates. The Fed has been buying around $24 billion in mortgage securities a month this year and around $17.5 billion in Treasurys, according to FTN Financial.

The Fed said all participants at its policy-setting meeting had agreed with the balance-sheet plans. Minneapolis Fed President Neel Kashkari cast the lone dissenting vote on Wednesday's decision to raise rates because he wanted to hold them steady.

Since officials last met in early May, they have faced conflicting signals about the economy on two items that matter most: employment and inflation. Solid job gains have pulled down the unemployment rate to lower-than-expected levels, at 4.3% in May, but inflation has unexpectedly slowed.

Ms. Yellen said officials are "monitoring inflation developments closely, " but warned against reading too much into a handful of recent one-off declines in consumer prices, such as wireless-phone plans, that have weighed on inflation gauges.

Fed officials marked down their projections for inflation this year, though they still see annual price gains reaching their 2% target by the end of 2018, in part because they expect tighter labor markets to ultimately help firm up prices.

Officials now expect prices excluding food and energy to rise 1.7% this year, from a projection of 1.9% in March. They lowered their unemployment rate forecast to 4.3% for the end of 2017 and to 4.2% at the end of 2018 and 2019, down from March projections of 4.5% for each of those years.

Officials' median expectation for the federal-funds rate showed few changes from projections released in March, and implies three more quarter-point increases in 2018 and three more in 2019.

The central bank had held short-term rates steady since March, when it raised them by a quarter point, the third increase since June 2006. The Fed held rates at near zero from the end of 2008 through most of 2015, before lifting the benchmark rate once in late 2015 and once in late 2016.

Despite recent increases in short-term rates, financial conditions have eased this year, with stocks rising to new highs and bond yields drifting lower. Mortgage rates, for example, have fallen to their lowest levels since November, with the average 30-year fixed-rate loan nearing 4%.

"We've been here before, where the Fed raises its rate, there's a little bump up, but then mortgage rates come back down," said Jim Klinge, a real-estate agent in Carlsbad, Calif., who says this year is shaping up to be his best since he began selling houses in 1984.

Given recent increases in short-term rates, "we should be at a 4.5% to 5% [mortgage] rate," said Mr. Klinge. "There is a disconnect, and it has been great for us."

Equity markets also have supported more initial public offerings. So far this year, there have been nearly twice as many IPOs compared with the year-earlier period, with around $21.8 billion in deals, up from $7.2 billion last year, according to Dealogic.

"It tells you that stock prices are higher, and people like to sell stock when stock markets move higher," said Citigroup's Mr. Levkovich.

Wednesday's rate increase had been largely anticipated by investors and analysts, but how the Fed's plans later this year will unfold is less clear. Markets have been skeptical the Fed will follow through with another rate increase this year because of signs that inflation's weakness may be more stubborn than the Fed expects.

Just how inflation develops in the months ahead is likely to shape how policy makers decide when to start the balance-sheet wind-down or raise rates again. Officials would want to see several more months of inflation readings before they significantly change their plans.

"We have more concerns on inflation than they do," said Mr. Gapen.

The Barclays economist said he sees risks of more persistent weakness than the transitory factors cited by Ms. Yellen and other officials, including from used-car prices and softer rent growth. Another price headwind, he said, looms from structural changes in the retail sector, with brick-and-mortar retailers struggling to maintain pricing power against online competitors.

Write to Nick Timiraos at nick.timiraos@wsj.com

(END) Dow Jones Newswires

June 14, 2017 19:37 ET (23:37 GMT)