- The Federal Reserve raised its key short-term rate by 0.75%.
- It’s the biggest hike in 28 years as the Fed tries to tamp down inflation by raising borrowing costs.
- The central bank signaled more rate hikes may be coming in 2022.
WASHINGTON–The Federal Reserve is rolling out the heavy artillery in its bid to fight a historic inflation spike that has shown little let-up.
But the aggressive strategy is expected to further slow the economy and increases the risk of recession. It already has triggered a brutal market sell-off.
The Fed raised its key short-term interest rates by three quarters of a percentage point Wednesday – its largest hike since 1994 – to a range of 1.5% to 1.75. It also downgraded its economic forecast.
It also signaled that more big moves may be coming. Fed officials forecast the federal funds rate will end 2022 at a range off 3.25% to 3.5%, according to their median estimate. That suggests officials are tentatively planning another three-quarters point increase in July and a half point rise in September before throttling back to more typical quarter-point increases the rest of the year.
“The (Fed’s policymaking committee) is strongly committed to returning inflation to its 2 percent objective,” the Fed said in a statement after a two-day meeting.
To put the Fed’s abrupt turnabout in perspective, the key rate began 2022 near zero and its half-point increase in March was the largest since 2000. At that time, officials predicted the rate would rise to about 1.9% by December.
The Fed’s hike Wednesday and its new projections are expected to ripple through the economy, sharply pushing up rates for credit cards, home equity lines of credit and mortgages, among other loans. Fixed, 30-year mortgages already have climbed to 5.23% from 3.22% early this year on the expectation of significant Fed moves.
At the same time, Americans, particularly seniors, should reap the benefits of higher bank savings rates after years of piddling returns.
The Fed lifts rates to curb borrowing, cool off an overheated economy and fend off inflation spikes. It lowers them to spur borrowing, economic activity and job growth.
The Fed’s sharp reversal on rates
Just in recent days, Fed officials have ratcheted up their rate hike plans amid signs that inflation appears more entrenched than previously thought, according to reports by Barclays and the Wall Street Journal. In early May, Fed Chair Jerome Powell suggested that half point rate increases were likely at both June and July meetings but policymakers had no plans for a three-quarters point move, a view that lifted markets.
But after starting to ease in April, the consumer price index (CPI) surged 8.6% annually in May, a new 40-year high, the Labor Department reported last week. Equally worrisome, the University of Michigan’s measure of consumer inflation expectations, which can affect actual price increases, also jumped last month.
“This raises the risk that a self-reinforcing inflationary cycle could take shape,” Barclays economists wrote in a note to clients.
A three-quarters point move sends “a resounding signal of the Fed’s resolve to guide inflation back to its 2% target,” Barclays said.
The Fed now expects its preferred yearly inflation measure, which is different than the CPI, to drop from 6.3% in April to 5.2% by the end of the year, up from its March estimate of 4.3%. It predicts a core reading that strips out volatile food and energy items will be 4.3% at year-end, above its prior 4.1% projection.
Slowing economic growth
The sharply higher interest rates are likely to further slow an economy that already has been moderating. The Fed on Wednesday said it expects the economy to grow 1.7% in both 2022 and 2023, down from its March estimate of 2.8% and 2.2%, respectively, according to officials’ median forecast.
And it predicts the unemployment rate, now just above a 50-year low at 3.6%, will rise to 3.7% by the end of the year and 3.9% by the end of 2023. It had projected a decline to 3.5%.
Economic output increased 5.7% last year, the most since 1984, on a reopening economy, increasing COVID vaccinations and massive federal aid to households.
The Fed’s bolder rate-hike strategy is an acknowledgement it’s now more willing to tolerate rising unemployment and the risk of recession to corral inflation, Barclays says. Last month, Powell and other Fed officials said the job market was so vibrant they likely could steer the economy to a “soft landing” of moderately slowing growth that keeps unemployment stable while taming inflation.
But while the labor market is still robust, adding about 400,000 jobs a month in recent months, the economy has already begun pulling back, both because of soaring inflation and rising interest rates. A measure of business investment rose less than expected in April. The Commerce Department said Wednesday that retail sales fell 0.3% in May. And higher mortgage rates are cooling the housing market.
Normally, the Fed nudges up rates to contain inflation. But it now runs the risk that big rate increase will topple an already-slowing economy into recession by next year.
Too much, too soon?
Some economists believe the Fed is going too far. Inflation is likely to slow as supply chain troubles continue to ease and more Americans return to the work force, relieving workers shortages and rapid wage growth.
“Our objection to this more aggressive (Fed) action is that it is unnecessary because the forces which have driven the recent inflation numbers are already fading,” Ian Shepherdson, chief economist of Capital Economics, wrote in a note to clients.
The Fed has been forced into its hard-nosed strategy because it underestimated inflation’s staying power through most of last year. Officials believed skyrocketing prices would retreat quickly as supply problems resolved and consumer purchases sparked by the recovery from the COVID downturn returned to normal. Russia’s war on Ukraine and the Delta variant, in part, disrupted that scenario.
Fed officials were more intent on supporting the recovering economy and ensuring Americans came back to a favorable job market than on curbing inflation.
The central bank on Wednesday also said it has started shedding the trillions of dollars in Treasury bonds and mortgage-backed securities it has amassed to lower long-term rates.
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.