WASHINGTON (`) – The Federal Reserve on Wednesday is poised to accelerate its most drastic move in three decades to tackle inflation by making it more expensive to borrow — for a car, a house, a business deal, a credit card purchase — all of which will financial strains on Americans and likely to weaken the economy.
However, with inflation soaring to a 40-year high, the Fed has come under extraordinary pressure to act aggressively to rein in spending and contain the price spikes that are plaguing homes and businesses.
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After the end of its most recent rate-setting meeting on Wednesday, the Fed will almost certainly announce that it is raising its short-term interest rate by half a percentage point – the largest rate hike since 2000. The Fed is likely to make another half-percentage point hike at its next meeting in June and possibly the next one thereafter in July. Economists foresee further rate hikes in the coming months.
In addition, the Fed is expected to announce on Wednesday that it will begin rapidly unwinding its huge holdings of Treasuries and mortgage bonds beginning in June — a move that will result in further tightening of credit.
Chairman Jerome Powell and the Fed will be taking these moves largely in the dark. No one knows how high the central bank’s short-term interest rate will have to rise to slow the economy and curb inflation. Officials also don’t know how much they can reduce the Fed’s unprecedented $9 trillion balance sheet before risking destabilizing financial markets.
“I liken it to reversing and using the rearview mirror,” says Diane Swonk, chief economist at consulting firm Grant Thornton. “They just don’t know what obstacles they’re going to face.”
However, many economists believe that the Fed is already acting too late. Even as inflation has skyrocketed, the Fed’s interest rate range is only 0.25% to 0.5%, a level low enough to spur growth. Adjusted for inflation, the Fed’s policy rate – which drives much consumer and corporate credit – is deep in negative territory.
That’s why Powell and other Fed officials have said in recent weeks that they want to raise rates “quickly” to levels that neither stimulate nor slow the economy — what economists call a “neutral” interest rate. Policymakers see a neutral interest rate at around 2.4%. But no one is sure what the neutral interest rate is at any given time, especially in an economy that is developing rapidly.
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If the Fed makes three half-point rate hikes this year and then three quarter-point hikes, as most economists expect, its interest rate would be around neutral by the end of the year. Those hikes would equate to the fastest pace of rate hikes since 1989, noted Roberto Perli, an economist at Piper Sandler.
Even dovish Fed officials like Charles Evans, President of the Federal Reserve Bank of Chicago, have advocated this path. (Fed “doves” typically prefer to keep rates low to support hiring, while “hawks” often support higher rates to curb inflation.)
Powell said last week that once the Fed hits its neutral interest rate, it may cut lending even further — to levels that would slow growth — “if that proves 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 course have become clearer in recent months as inflation has picked up. That’s a notable change from just a few months ago: After the Fed’s January meeting, Powell said, “It’s not possible to predict with any degree of confidence exactly which path for our policy rate will prove appropriate.”
Jon Steinsson, an economics professor at the University of California, Berkeley, thinks the Fed should issue more formal guidance given the rapid changes in the economy following the pandemic recession and Russia’s war on Ukraine, which has exacerbated supply shortages in the US World. The Fed’s most recent formal guidance in March had called for seven quarter-point rate hikes this year – a pace that is already hopelessly outdated.
Steinsson, who in early January had called for a quarter-point hike at each meeting this year, said last week: “It’s appropriate to do things quickly to send the signal that quite significant tightening is needed.”
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One challenge for the Fed is that the neutral interest rate is now even more uncertain than usual. When the Fed’s interest rate hit 2.25% to 2.5% in 2018, it triggered a drop in home sales and financial markets fell. The Powell Fed responded with an about-face, cutting rates three times in 2019. This experience suggested that the neutral rate could be lower than the Fed thinks.
But given how much prices have risen since then, driving inflation-adjusted interest rates down, the Fed rate that would actually slow growth could be well over 2.4%.
The Fed’s balance sheet shrinking adds another uncertainty. This is especially true given that the Fed is expected to roll off $95 billion worth of securities each month as they mature. That’s nearly double the $50 billion pace it maintained pre-pandemic when it last reduced its bond holdings.
“Twisting two knobs at once makes it a little more complicated,” said Ellen Gaske, senior economist at PGIM Fixed Income.
Brett Ryan, an economist at Deutsche Bank, said balance sheet contraction will equate to roughly a three-quarter-point increase through next year. This, combined with expected rate hikes, would result in around 4 percentage point tightening through 2023. Such a dramatic rise in borrowing costs would push the economy into recession by the end of next year, Deutsche Bank predicts.
But Powell is counting on the robust labor market and solid consumer spending to spare the US such a fate. Although the economy contracted at an annual rate of 1.4% in the January-March quarter, businesses and consumers increased spending at a solid pace.
If sustained, this spending could keep the economy growing for the coming months and perhaps beyond.
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