Higher interest rates will not upend growth, but reflect the underlying strength of the U.S. economy according to a report released today by TD Economics, an affiliate of TD Bank.

"With domestic spending and job creation running well above trend, the Federal Reserve had more than enough cause to finally move interest rates off zero," TD Chief Economist, Beata Caranci, said. "The economic drivers within America are mainly focused inward at this point in the cycle, and the foundation is strong enough to support modestly higher rates. Plus, nobody is expecting this rate hike cycle to mirror those of the past; it will be running at half-speed."

Led by household and business spending, the economy is expected to grow by 2.4 percent in 2016 and 2.3 percent in 2017. However, as Caranci noted, "the headline GDP growth figure merely creates the illusion that the economic foundation is weaker than it truly is, since domestic demand will grow at a faster pace."

With continued strong job growth, the unemployment rate will continue to fall, hitting a trough of 4.7 percent in early 2017.

Ups and downs in 2015...

The economy had its share of ups and downs over the past year. On the downside, bad weather, cuts to oil and gas investment, and a weak global growth environment exacerbated by a rising dollar contributed to the overall picture. On the upside, job growth was persistently strong, real wages rose and household spending accelerated.

"We have long ascertained that the economy would reflect the push-and-pull forces from weak external demand and strong domestic demand. This is exactly what is playing out," Caranci said. "Fortunately, the externally exposed sectors of the economy make up a comparatively small portion of U.S. economic activity. The rest of the economy is making up for them."

Stronger, domestic-led growth in 2016...

The good news is that the headwinds to growth should blow a little softer over the next year, while the tailwinds pick up speed. This is perhaps best seen in the adjustment to lower oil prices.

"Falling energy investment cut 0.4 percentage points from growth over the past year," Caranci said. "This drag will fade over the next. As it does, the benefit to household spending and (non-energy) business investment will dominate."

The average saving to households from lower gasoline prices amounts to over $700. Some of this has been spent this year, but much of it will make its way into spending over the coming year.

Federal Reserve calls off emergency level rates...
 
The ongoing recovery sets the stage for higher interest rates. Seven years after bringing rates to zero and nearly a decade since the last increase in rates, the Federal Reserve has taken the first step in normalizing monetary policy with an increase in the fed funds range to 0.25 percent to 0.50 percent.

"The Fed's decision to raise its target interest rate reflects the strength of the labor market," Caranci said. "Nonetheless, the pace of tightening will be gradual, reflecting the need for the economy to continue to grow above trend in order absorb the remaining slack in the labor market, as well as the disinflationary impulse from an improving, but still generally sluggish, global growth environment."

Caranci expects the Federal Reserve to bring the fed funds rate up by less than a full percentage point, to 1.25 percent by the end of 2016. By the end of 2017, the fed funds rate will likely only be at 1.75 percent, which is still a highly stimulative monetary setting.

TD Economics provides analysis of global economic performance and forecasting, and is an affiliate of TD Bank, America's Most Convenient Bank®.

The complete findings of the TD Economics Report.