The COVID-19-induced era of rock-bottom interest rates is over – just as the U.S. finally seems to be turning the corner on the pandemic.
Yet while falling COVID-19 cases and solid consumer demand are helping clear the way for higher rates, the Federal Reserve is taking aim at the pandemic’s stubborn economic legacy: soaring inflation.
Moving to curtail a historic surge in consumer prices, the Fed raised its key short-term interest rate Wednesday – by a quarter-percentage point – for the first time in more than three years and forecast six more hikes this year. That’s up from the three total quarter-point increases Fed officials predicted in December and more than the six moves many top economists predicted this week. The Fed forecast another four hikes in 2023.
The central bank also sharply boosted its inflation forecast, largely as a result of Russia’s attack on Ukraine, while lowering its estimate of economic growth, highlighting the quandary the Fed faces as it tries to tame price increases without tipping the economy into recession.
“The invasion of Ukraine by Russia is causing tremendous human and economic hardship,” the Fed said in a statement after a two-day meeting. “The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”
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During a video new conference, Fed Chair Jerome Powell said officials believe the economy can handle multiple rate hikes without slipping into recession.
“It’s clearly time to raise interest rates,” Powell said. “We do feel the economy is very strong and well positioned to withstand” higher rates.
What do Fed rate hikes mean?
Traditionally, the Fed increases rates to curb borrowing, temper an overheated economy and fend off inflation spikes. It lowers them to spur borrowing, economic activity and job growth. Now, it potentially faces a worst-of-all-worlds scenario of spiraling inflation and slowing growth.
Wednesday’s hike bumps up the federal funds rate – which is what banks charge each other for overnight loans – from near zero to a range of 0.25% to 0.5%. It’s expected to ripple through the economy, pushing up rates for credit cards, home equity lines of credit and adjustable-rate mortgages, among other loans. But Americans, especially seniors, should start to get some relief from puny rates for savings accounts and CDs.
How did rate hike affect stock market?
Immediately following the Fed’s decision stocks fell – but eventually reversed course.
After trading higher leading up to the decision, the Dow Jones industrial briefly turned negative but closed 1.6%, or 519 points, higher Wednesday. The S&P 500 and Nasdaq composite nearly wiped away their gains from earlier in the day. But the S&P 500 closed up 95 points, or 2.2%. And the Nasdaq rose 489 points, or 3.8%.
The yield on the 10-year Treasury rose above 2.2% after the announcement. That’s the highest level 10-year bond yields have been in three years. Hours later, yields fell to around 2.19%.
St. Louis Fed bank chief James Bullard dissented from the decision, saying he preferred to raise the rate by a half-point. In its statement, the central bank added that it anticipates “ongoing increases…will be appropriate.”
Although Powell told Congress last month that he supported a quarter-point increase at the March meeting, economists have debated how aggressive the Fed will be in the months ahead amid a worrisome economic backdrop.
“We have plans to raise interest rates steadily,” he told reporters Wednesday, noting the Fed’s forecast for six more hikes imply it will act at each remaining meeting this year. If the central bank needs to move more quickly, “then we’ll do so,” he added, suggesting a half point hike is possible at some meetings.
Is the Fed raising rates further in 2022 and beyond?
The Fed now expects its benchmark rate to rise to 1.9% by year-end – above its pre-pandemic level – and 2.8% by the end of 2023, higher than many top economists projected.
Since fall, Fed policymakers have been gearing up to combat a bout of inflation that has steadily hit new 40-year highs, with the consumer price index (CPI) rising 7.9% annually in February.
Russia’s invasion of Ukraine last month compounded the problem by further juicing fast-rising gasoline and food prices – Russia is among the world’s top oil producers – and worsening global supply-chain bottlenecks. The average price of regular gasoline hit $4.32 a gallon Tuesday, up from $3.50 just a month ago, according to AAA.
Worker shortages spawned by the pandemic are also stoking inflation by forcing employers to bid up wages to attract a smaller pool of job candidates. That, in turn, is prompting companies to raise prices to maintain profit margins.
Yet the leap in prices is also dampening consumer spending, and the Ukraine war is battering the stock market and global growth – all of which is set to slow the U.S. economy.
How is the current U.S. economy?
The Fed on Wednesday said it expects the U.S. economy to grow 2.8% in 2022, down from its December estimate of 4%, according to officials’ median projections. That’s still sturdy growth by historical standards but analysts worry an intensifying war and sharp rate increases could slow the economy further or even nudge it into recession.
The Fed estimates its preferred annual inflation measure (which is different than the CPI) will end the year at 4.3% — well above its 2% target — before easing to 2.7% in 2023, up from its prior forecasts of 2.6% and 2.3%, respectively. It predicts a core measure that strips out volatile food and energy items will be 4.1% at year-end and 2.7% at the close of 2023, up from prior estimates of 2.7% and 2.3%.
Fed officials still expect unemployment, now 3.8%, to drop to its pre-pandemic mark of 3.5% – a 50-year low – by the end of this year and to remain at that level by the close of 2023. That suggests the Fed doesn’t expect inflation or rising rates to derail the economy or job market.
What is inflation rate for 2022?
Inflation is expected to moderate this year as the pandemic eases and more truck drivers, along with factory, warehouse and port employees, return to work, helping alleviate the supply troubles. But the increase in the consumer price index is now expected to peak in late spring at 8.7%, higher than previously believed and it will take longer for inflation to subside, predicts economist Kathy Bostjancic of Oxford Economics.
Although Powell said the Fed believes it can boost rates to lower inflation while maintaining a strong labor market, he made it clear that reining in inflation is the priority.
“The plan is to restore price stability,” he said, noting it’s necessary for low unemployment in the long run. “Price stability is an essential goal.”
In an opinion piece in Tuesday’s Washington Post, Larry Summers, Treasury secretary under President Obama, said the Fed took inflation too lightly over the past year and “will have to head in a dramatically different direction” to “avoid stagflation (high inflation and stalled growth) and the associated loss of public confidence in our country now.”
What other moves did the Fed make?
The Fed on Wednesday also said it it will begin reducing its trillions of dollars in Treasury bonds and mortgage-backed securities “at a coming meeting” after launching the bond-buying at the start of the pandemic to lower long-term rates. The purchases ballooned the Fed’s balance sheet to about $8.8 trillion.
Rather than sell the bonds outright, which could disrupt markets, the Fed plans to gradually trim its holdings by not reinvesting the proceeds from some of the assets as they mature. The shrinking balance sheet will also nudge mortgage and other long-term rates higher.
Wednesday’s moves mark a reversal for a central bank that had been focused on helping the nation heal from the recession and 22 million job losses caused by the pandemic. In March 2020, as the COVID-19 crisis upended the economy, the Fed slashed its benchmark rate to near zero and launched the bond buying.
As recently as early November, Powell said officials believed the inflation surge was transitory and would ease as both the supply snags and pent-up consumer demand from a reopening economy pulled back.
He said the Fed would be patient and hold off on raising rates so the economy could reach full employment – an environment in which virtually anyone who wants a job has one.
But by late November, Powell acknowledged the supply problems and inflation would linger longer than expected. The U.S. is still 2.1 million jobs short of its pre-pandemic level and the share of people over 16 working or looking for jobs is at 62.3%, below the 63.4% pre-crisis mark. But many Americans retired early during the pandemic and most are not expected to return, and Powell has said he believes the economy is at full employment.
Contributing: Elisabeth Buchwald