Fed raises rates by 25 bps: What it means for inflation and labour market

The Federal Reserve's estimates for unemployment rate by end of this year moved down to 4.3%

The Federal Reserve has raised the interest rates at which banks borrow by 25 basis points to 1.12 per cent on Wednesday for the second time in three months, brushing off a recent run of mixed economic data. It forecasted one more hike this year.

The Fed has now raised rates four times as part of a normalisation of monetary policy that began in December 2015. The central bank had pushed rates to near zero in response to the financial crisis.

What reasons did the Federal Reserve cite?

1. The US central bank's rate-setting committee said the economy had continued to strengthen, job gains remained solid and indicated it viewed a recent softness in inflation as largely transitory.

2. The Fed also gave a first clear outline on its plan to reduce its $4.2 trillion portfolio of Treasury bonds and mortgage-backed securities, most of which were purchased in the wake of the 2007-2009 financial crisis and recession.

3. It expects to begin the normalisation of its balance sheet this year, gradually ramping up the pace. The plan, which would feature halting reinvestments of ever-larger amounts of maturing securities, did not specify the overall size of the reduction.

What is the initial cap?

The initial cap for the reduction of the Fed's Treasuries holdings would be set at $6 billion per month, increasing by $6 billion increments every three months over a 12-month period until it reached $30 billion per month.

For agency debt and mortgage-backed securities, the cap will be $4 billion per month initially, rising by $4 billion at quarterly intervals over a year until it reached $20 billion per month.

How will it impact inflation?

1. Fed policymakers forecast US economic growth of 2.2 per cent in 2017, an increase from the previous projection in March. Inflation was expected to be at 1.7 per cent by the end of this year, down from the 1.9 per cent previously forecast.

2. A retreat in inflation over the past two months has caused jitters that the shortfall, if sustained, could alter the pace of future rate hikes. But the Fed maintained its forecast for three rate hikes next year.

3. The Fed's preferred measure of underlying inflation has retreated to 1.5 per cent, from 1.8 per cent earlier this year, and has run below the central bank's two per cent target for more than five years.

4. Janet Yellen indicated the Fed still remained confident inflation would rise to its target over the medium term, bolstered by what she described as a robust labour market that is continuing to strengthen.

The Fed's estimates for the unemployment rate by the end of this year moved down to 4.3 per cent, the current level, and to 4.2 per cent in 2018, indicating the Fed believes the labour market will continue to tighten.

The median estimate of the long-run neutral rate, which is seen as the level of monetary policy that neither boosts nor slows the economy, was unchanged at three per cent.