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MARKET TRENDS: As Global Economy Falters, Fed Slows Plan to Hike Interest Rates

March 28, 2016

On Wednesday, the U.S. Federal Reserve halted its plans for raising interest rates due to concerns over weak inflation levels and uncertain global economic health. The world's most powerful central bank left the federal funds rate unchanged between 0.25% – 0.5%, contrary to expectations at the beginning of the year that interest rates would be hiked this month.

Policymakers also backtracked from their December prediction of increasing rates by one percentage point this year. They are now likely to increase the Fed Funds Rate twice instead of four times in 2016 – this new guidance translates into a total rate increase of just half a percentage point.

The central bank forecast an annual GDP growth of about 2% in 2016. Given that the U.S. economy has remained mostly unaffected by global economic and financial conditions, policymakers expect it to "expand at a moderate pace" this year. However Fed Chairwoman Janet Yellen indicated that it would be wise to exercise caution, as the global environment continues to pose risks.

Inflation is predicted to be at a level of about 1.2% in 2016, falling short of the central bank's target of 2%. The Fed's monthly statement said that "Inflation is expected to remain low in the near term, in part because of earlier declines in energy prices, but to rise to 2 percent over the medium term as the transitory effects of declines in energy and import prices dissipate and the labor market strengthens further." In light of current conditions, the Fed is likely to carefully monitor actual and expected progress toward its inflation goal, and review its policy accordingly.

The Federal Open Market Committee (FOMC) statement at the conclusion of the recent two-day meeting did not specify the timing of the next interest rate hike. Experts do not anticipate another rate hike before June. There are two reasons behind the Fed's decision to slow down. Firstly, raising interest rates at a time when other major central banks are pursuing aggressive stimulus campaigns could hamper domestic growth. For example, a rate hike may lead to a strengthening dollar which would reduce the demand for American exports.

Secondly, Ms. Yellen said that tighter conditions in financial markets are already raising borrowing costs faced by some corporations – this is equivalent to a Fed interest rate increase.

The Fed conveyed that there exists room for improvement in the labor market – policymakers expect the unemployment rate to fall to 4.5% in 2018, from the December median forecast of 4.7%. Ms. Yellen indicated that although the labor market is showing robust signs of growth, wage growth is still weak and leaves much to be desired. Other labor market indicators also suggest that the economy has not yet fully absorbed the surplus of workers – for example, the share of part-time workers who want full-time jobs remains high.

The Fed's decision to prolong its stimulus campaign was welcomed by investors. While US stocks inched into the green in late evening trading on Wednesday, yields on U.S. government debt dropped with the two-year note marking its biggest decline in six months. Earlier in the day, bond yields had risen on investors' expectations that the resilience displayed by U.S. economy over the past month may encourage the Fed to raise rates, possibly as soon as April. Mortgage rates also were markedly lower since the FOMC adjourned.

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