Paul Davidson, USA TODAY
WASHINGTON – The Federal Reserve rolled out the heavy artillery in its bid to fight a historic inflation spike that has shown little letup.
The aggressive strategy is likely to further slow the economy and increases the risk of recession. It 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 downgraded its economic forecast.
More big moves may come. Fed officials forecast the federal funds rate will end 2022 at a range of 3.25% to 3.5% and next year at close to 4%, according to their median estimate.
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That suggests officials tentatively plan aggressive increases in July and September before throttling back to more typical quarter-point increases the rest of the year.
“I do not expect moves of this size to be common,” Fed Chair Jerome Powell said of Wednesday’s hike.
That sent stocks higher, with the S&P 500, which fell into a bear market earlier this week, closing up 54 points or 1.5%.
At a news conference, Powell said the Fed will probably choose between a half-point and three-quarters of a point hike at its meeting in July.
“We thought that strong action was warranted at this meeting, and today we delivered it,” Powell said. “We aren’t going to declare victory until we really see convincing evidence, compelling evidence that inflation is coming down.”
To put the Fed’s 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.
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What does a rate hike do?
The Fed’s hike Wednesday and its new projections are likely 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 have climbed to 5.23% from 3.22% early this year on the expectation of Fed moves.
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.
Inflation shows little letup
Fed officials ratcheted up their rate hike plans amid signs that inflation appears more entrenched than they thought, according to reports by Barclays and The Wall Street Journal.
In early May, Powell suggested that half-point rate increases were likely at meetings in June and July. Policymakers had no plans for a three-quarters point move, a view that lifted financial markets at the time.
After starting to ease in April, the consumer price index surged 8.6% annually in May, a 40-year high. Equally worrisome, the University of Michigan’s measure of consumer inflation expectations, which can affect actual price increases, jumped last month.
“We take that very seriously,” Powell said. “It was quite eye-catching.”
Barclays said the bump up in inflation expectations “raises the risk that a self-reinforcing inflationary cycle could take shape.”
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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 expects its preferred yearly inflation measure, which is different from 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 the economy on purpose
The sharply higher interest rates are likely to further slow an economy that has been moderating. The Fed said Wednesday 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.
It predicts the unemployment rate, just above a 50-year low at 3.6%, will rise to 3.7% by the end of the year and 4.1% by the end of 2024. It had projected a decline to 3.5% this year.
Economic output increased 5.7% last year, the most since 1984, on a reopening economy, increasing COVID-19 vaccinations and massive federal aid to households.
The Fed’s bolder rate-hike strategy is an acknowledgment it’s more willing to tolerate rising unemployment and the risk of recession to corral inflation, Barclays said. Last month, Powell and other Fed officials said the job market was so vibrant they probably could steer the economy to a “soft landing” of moderately slowing growth that kept unemployment stable while taming inflation.
Powell said Wednesday he still believes such a scenario is possible, but “the pathway for us to get there – it’s not getting easier.”
Though the labor market is robust, adding about 400,000 jobs a month in recent months, the economy has begun pulling back 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. Higher mortgage rates are cooling the housing market.
Powell said, “(Consumer) demand overall is still very hot in the economy,” and the Fed aims to use higher rates to rein in inflation.
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Normally, the Fed nudges up rates to contain inflation in a strong economy. It runs the risk that a big rate increase will topple a slowing economy into recession by next year.
Powell acknowledged the Fed’s projected federal funds rate of close to 4% would be “moderately restrictive,” meaning it would hurt economic growth. He said he thinks 4.1% unemployment — the Fed’s estimate for late 2024 — is historically low and there’s room to bring inflation back to the Fed’s 2% target without tipping the economy into recession.
Is the Fed raising rates too fast?
Some economists said the Fed is going too far. Inflation is likely to slow as supply chain troubles ease and more Americans return to the workforce, relieving worker 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 was forced into its hard-nosed strategy because it underestimated inflation’s staying power through most of last year. Officials said skyrocketing prices would retreat quickly as supply problems were resolved and consumer purchases sparked by the recovery from the COVID-19 downturn returned to normal. Russia’s war on Ukraine and the delta variant of the coronavirus, 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.
“Clearly, the FOMC was late to the game in responding to elevated inflation, and just as clearly, they seem intent on making up for lost time,” Richard Moody, chief economist of Regions Financial, wrote to clients.
The central bank also said Wednesday it started shedding 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.
Contributing: Elisabeth Buchwald
This article originally appeared on USA TODAY: Fed rate hike: Key interest rate raised 0.75 points to fight inflation
