WASHINGTON – Federal Reserve officials hiked interest rates by a quarter point on Wednesday as they tried to balance two conflicting issues: the risk that inflation could remain fast and the risk that turmoil in the banking system could slow the economy sharply.
The Fed hiked interest rates to a range of 4.75 percent to 5 percent on Wednesday, and officials are forecasting another rate hike in 2023 — though they’ve indicated that even that is uncertain. In doing so, policymakers were trying to signal that they remained focused on quelling price hikes but were also alert to financial threats.
“In assessing the need for further rate hikes, we will focus on the incoming data and the evolving outlook, and in particular our assessment of the actual and expected impact of the credit crunch,” Fed Chair Jerome H. Powell said ahead of his press briefing the meeting.
The Fed’s statement said some additional rate hikes “might be warranted,” and Mr. Powell stressed that “might” be crucial: Officials don’t know that yet.
His comments underscored that the prospects of whether interest rates would rise further – and if so, by how much – had been clouded by turbulence in the banking sector, which could make it harder to obtain credit and slow the economy.
Officials forecast they would cut rates more slowly than expected next year, leaving rates stuck at 4.3 percent by the end of 2024, up from 4.1 percent. This suggested that the struggle to keep inflation stable could be longer and more gradual than many expected just a few months ago, although the outlook is clouded by the banking turmoil.
Together, the forecasts and Mr Powell’s comments underscored that his central bank is facing a complicated moment – and is trying to buy itself time to decide how to respond.
The Fed has been raising interest rates at the fastest rate since the 1980s over the past year to try to cool down a hot economy. Nonetheless, inflation has remained surprisingly persistent and the labor market remains strong. These facts would likely have prompted a more aggressive response from the Fed.
But the high-profile bank failures of recent weeks have underscored the risk that rapid rate moves by the Fed could stoke financial instability. Silicon Valley Bank, which failed on March 10, did so in part because it had accumulated large losses on its securities portfolio as interest rates rose. More critically, banking problems threaten to weigh on lending and spending, increasing the risk of a recession.
“The bottom line is: Credit conditions will tighten and the Fed recognizes that,” said Diane Swonk, chief economist at KPMG. The Fed “would like a slow cooldown,” she added. “They just don’t want refrigeration. And that increases the likelihood of the economy falling through the ice.”
Stocks, which initially surged after the Fed’s decision was announced, fell sharply on Wednesday, ending the day down 1.65 percent as investors digested the Fed’s interest rate move and comments from Treasury Secretary Janet Yellen , which suggested the government was unconcerned with a plan to expand comprehensive protections for uninsured deposits.
The ongoing nervousness about the banking system comes at a time when the economy otherwise appears strong – despite the Fed’s policy adjustments.
The Fed has been raising interest rates rapidly since March 2022, making it more expensive to borrow in hopes of cutting spending and eventually weighing on inflation. Officials made four consecutive three-quarter-point rate hikes over the past year before slowing to a half-point in December and a quarter-point in early February.
Just two weeks ago, many economists and investors thought central banks might accelerate their rate hikes at this meeting because the incoming economic data had retained so much momentum. Policymakers had indicated that they might revise their forecasts for rate hikes in 2023 upwards.
“Just a few weeks ago it looked like we might have to raise interest rates more than expected – throughout the year,” admitted Mr Powell on Wednesday.
But the Fed chairman explained that the banking problems had changed the outlook. By making it harder for consumers to access credit to buy homes, cars or other large purchases, the problems could weigh on demand and allow the Fed to adjust interest rates less drastically.
“Recent developments are likely to result in tighter credit conditions for households and businesses, weighing on economic activity, the hiring rate and inflation,” the Fed policy committee said in its statement after the meeting. “The extent of this impact is uncertain.”
Goldman Sachs economists estimate that the effect could match the slowdown triggered by a Fed rate hike or two. Mr Powell seemed to indicate during his press conference that his estimate – although far from clear – was in that range.
“You can think of it as the equivalent of a rate hike, or maybe more than that,” he said. “Of course, it’s not possible to estimate that precisely today.”
But even with a bank-induced hit to the economy, the process of restoring stable inflation could take time.
Based on their new economic estimates, policymakers expected rapid price increases to be a more sustained problem. Officials expected inflation to end 2023 at 3.3 percent, up from 3.1 percent in their December forecast. This measure of inflation was 5.4 percent in January.
Central bankers are targeting average inflation of 2 percent over time. While price increases have slowed from very high levels last year — the Fed’s favorite index of inflation peaked at about 7 percent last summer — that progress hasn’t been as steady as many had hoped.
Sustained price increases strain family budgets, and there is a risk that a long period of rapid inflation could make price increases a more permanent feature of the American economy.
Central bankers try to avoid that. By raising interest rates rapidly over the past year, they hoped to cool growth and bring inflation under immediate control. While rapid monetary policy adjustments increase the risk of financial turmoil and other troubles, central bankers have feared that inflation will be harder and more painful to root out once it becomes entrenched in everyday household and business behavior.
Once people are used to asking for big raises to cover rising costs, and companies are used to making regular price increases, it might take a major economic downturn to change those habits and change the trajectory of price increases.
“We need to get inflation down to 2 percent,” Powell said. “The cost of failure is much higher.”
A key question is whether the Fed will be able to slow down the economy enough to cool inflation without a recession. Mr Powell hinted that he still thought such a “soft landing” was a possibility – although he acknowledged that recent upheaval in the banking sector has not helped.
“I think that way still exists,” said Mr. Powell. “We’re definitely trying to find it.”
Wall Street analysts have warned that risks are greater in a world of financial turmoil, as problems in the banking sector can easily spill over to Main Street.
“You have the trigger that can lead to a deeper recession — can lead to a hard landing,” said Priya Misra, head of global rates strategy at TD Securities.
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