The Federal Reserve will fight inflation with the fastest rate hikes in decades

WASHINGTON >> The Federal Reserve is poised this week to accelerate its most drastic steps in three decades to attack inflation by making it more expensive to borrow (for a car, a house, a business, a credit card purchase), all of which will worsen Americans’ financial stress is likely to weaken the economy.

Yet with inflation rising to a 40-year high, the Fed has come under extraordinary pressure to act aggressively to cut spending and curb price spikes that are plaguing households and businesses. .

After its latest rate-setting meeting ends on Wednesday, the Fed will almost certainly announce that it will raise its benchmark short-term interest rate by half a percentage point, the steepest rate hike since 2000. Fed carry out another half point rate hike at its next meeting in June and possibly the next in July. Economists expect even more rate hikes in the coming months.

In addition, the Fed is also expected to announce on Wednesday that it will begin rapidly drawing down its large stash of Treasury and mortgage bonds starting in June, a move that will have the effect of further tightening credit.

Chairman Jerome Powell and the Fed will take these steps largely in the dark. No one knows how high the central bank’s short-term rate needs to be to slow the economy and contain inflation. Officials also don’t know how much they can reduce the Federal Reserve’s record $9 trillion balance sheet before risking destabilizing financial markets.

“I compare it to driving in reverse using the rearview mirror,” said Diane Swonk, chief economist at consultancy Grant Thornton. “They just don’t know what obstacles they’re going to run into.”

However, many economists think that the Fed is already acting too late. Even though inflation has skyrocketed, the Federal Reserve’s benchmark rate is in a range of just 0.25% to 0.5%, a level low enough to stimulate growth. Adjusted for inflation, the Federal Reserve’s key rate, which influences many consumer and business loans, is in negative territory.

That’s why Powell and other Fed officials have said in recent weeks that they want to raise rates “quickly,” to a level that neither boosts nor restrains the economy, what economists call the “neutral” rate. Policymakers consider a neutral rate to be about 2.4%. But no one is sure what the neutral rate is at any given time, especially in a rapidly evolving economy.

If, as most economists expect, the Fed makes three half-point rate hikes this year and then follows up with three-quarter-point hikes, its rate would roughly reach neutrality by the end of the year. Those increases would equate to the fastest pace of rate hikes since 1989, said Roberto Perli, an economist at Piper Sandler.

Even dovish Fed officials like Charles Evans, president of the Federal Reserve Bank of Chicago, have endorsed that path. (The Fed “doves” generally prefer to keep rates low to support hiring, while the “hawks” often support higher rates to curb inflation.)

Powell said last week that once the Fed reaches its neutral rate, it could further tighten credit, to a level that would restrict growth, “if it turns out to be appropriate.” Financial markets are pricing in a rate of up to 3.6% by mid-2023, which would be the highest in 15 years.

Expectations about the Fed’s path have become clearer in recent months as inflation has intensified. That’s a sharp change from just a few months ago: After the Fed met in January, Powell said: “It’s not possible to predict with much confidence exactly which path our benchmark rate will turn out to be appropriate.”

Jon Steinsson, an economics professor at the University of California, Berkeley, believes the Fed should provide more formal guidance, given how quickly the economy is changing in the wake of the pandemic recession and Russia’s war on Ukraine, which has exacerbated shortages. supply all over the world. world. The Fed’s most recent formal forecast, in March, had projected seven quarter-point rate hikes this year, a pace that is already hopelessly out of date.

Steinsson, who in early January had called for a quarter-point increase at each meeting this year, said last week: “It’s appropriate to do things quickly to send the signal that a fairly significant amount of tightening is needed.” .

One challenge facing the Fed is that the neutral rate is even more uncertain now than usual. When the Fed’s key rate hit 2.25% to 2.5% in 2018, it caused a drop in home sales and financial markets fell. Powell’s Fed responded with a U-turn: It cut rates three times in 2019. That experience suggested the neutral rate may be lower than the Fed thinks.

But given how much prices have soared since then, thus lowering inflation-adjusted interest rates, any Fed rate that actually slows growth could be well above 2.4%.

The shrinking of the Fed’s balance sheet adds another uncertainty. That’s particularly true given that the Fed is expected to allow $95 billion worth of securities to be withdrawn each month as they come due. That’s nearly double the $50bn pace it held before the pandemic, the last time it reduced its bond holdings.

“Turning two knobs at the same time makes it a little more complicated,” said Ellen Gaske, chief economist at PGIM Fixed Income.

Brett Ryan, an economist at Deutsche Bank, said the balance sheet reduction will be roughly equivalent to increases of three-quarters of a point through next year. When added to expected rate hikes, that would translate to about 4 percentage points of tightening through 2023. Such a dramatic rise in borrowing costs would push the economy into recession late next year, Deutsche Bank forecasts. .

Yet Powell is counting on the strong job market and strong consumer spending to spare America that fate. Although the economy contracted in the January-March quarter at an annual rate of 1.4%, businesses and consumers increased their spending at a solid pace.

If sustained, that spending could keep the economy expanding for months to come and perhaps beyond.

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