Federal funds target rate
Federal funds target rate
The Federal Reserve stepped up its attack on rapid inflation on Wednesday, approving its biggest interest rate hike since 2000, detailing a plan to reduce its huge bond holdings and signaling that it will continue to work to cool the economy as that it is trying to curb the fastest rising prices in four decades.
Yet investors have found a reason to relieve themselves. As the Fed raised interest rates by half a percentage point and its chairman, Jerome H. Powell, said similar increases would be “on the table” at future Fed meetings, he dismissed the idea that policymakers were considering an even bigger move, as some investors had feared.
This insurance has helped push stock market indices higher. The S&P 500 rose 3%, the biggest jump since May 2020.
Many on Wall Street are watching the Fed’s path nervously as it tries to bring inflation down, fearing authorities will slow demand so much that the economy could tip into a painful recession. As the Fed withdraws its monetary aid at the fastest rate in decades, Mr. Powell’s comments showed that the central bank was trying to chart a quick, but not drastic, course.
“The markets took it like this: the Fed isn’t overdoing it,” said Priya Misra, head of global rates strategy at TD Securities.
Still, the Fed’s series of policy changes underscored that the central bank is serious about the cooling economy and labor market. Officials are increasingly concerned that the price increases, which have lasted longer than many economists had expected, could become more permanent. By raising rates and cutting its nearly $9 trillion in bonds, the Fed will raise borrowing costs across the economy, measures aimed at slowing demand.
“Inflation is far too high and we understand the difficulties it is causing, and we are moving quickly to bring it down,” Powell said at a press conference on Wednesday. “We have both the tools we need and the determination it will take to restore price stability.”
Policymakers have spent most of 2021 hoping inflation would abate on its own as supply shortages ease and the economy stabilizes after the early disruptions of the pandemic. But normality has not yet returned and inflation has only accelerated. Today, new pandemic-related lockdowns in China and war in Ukraine are driving up the prices of goods, food and fuel even further. At the same time, workers are scarce and wages are rising rapidly in the United States, fueling higher prices for services as consumer demand remains strong.
Mr. Powell noted that developments in China and Ukraine could have a significant impact on inflation.
“They are both capable of preventing further progress in healing supply chains, or even temporarily worsening supply chains,” Powell said. Although he noted that the Fed’s tools operate on demand, not supply, he said that “there is work to be done on demand.”
Fed officials decided they no longer had the luxury of waiting for inflation to moderate on its own. Prices have climbed 6.6% in the year to March, according to the Fed’s preferred measure of inflation, more than three times the average annual increases of 2% that the Fed is targeting.
Authorities began raising interest rates in March and recently signaled that they would raise borrowing costs to the point where they would begin to dampen the economy. Powell said once that target is met, officials would assess the economy’s performance and continue to raise rates if necessary. The Fed’s key rate is now set in a range of 0.75 to 1%.
“We must do everything we can to restore stable prices,” he said. “Everyone will be better off if we can get this job done – the sooner the better.”
Still, Powell indicated that, at least for now, the Fed was trying to contain prices in a way that didn’t sink the economy. Some Fed officials had signaled that a 0.75 percentage point move could be possible – but Powell said on Wednesday that such a large increase is “not something the committee is actively considering”.
That comment helped appease investors, who have spent weeks worrying that the Fed might decide to overcorrect after moving too slowly away from policies aimed at fueling growth.
“The market was really spooked” by the potential for a three-quarter point upside, TD’s Ms Misra said. “President Powell tried to market this as a soft-landing hike, and he succeeded.”
Deciding how quickly to remove political support is a difficult exercise. Central bankers are hoping to act decisively enough to stop soaring prices without curbing growth so aggressively that they tip the economy into a deep slowdown.
Mr Powell nodded at this balancing act, saying: ‘I expect it to be very difficult – it won’t be easy.’ But he said the economy had a good chance “of having a soft landing, or rather a soft landing”.
He later explained that it might be possible to “restore price stability without a recession, a severe downturn and significantly higher unemployment.”
The balance sheet plan released by the Fed on Wednesday was in line with what analysts had expected, which likely also contributed to the market’s sense of calm. The Fed will begin to reduce its assets by nearly $9 trillion in June by allowing Treasury and mortgage-backed debt to mature without reinvestment. He will eventually let up to $60 billion in Treasury debt expire each month, as well as $35 billion in mortgage-backed debt, and the plan will be fully implemented from September.
By reducing its bond holdings, the Fed is likely to slow financial markets – bond prices will fall, pushing yields higher, and riskier investments like stocks will become less attractive. It could also help cool the housing market by pushing up longer-term borrowing costs, which track bond yields, reinforcing the effect of central bank interest rate hikes.
In fact, mortgage rates have already started to climb, climbing almost two percentage points since the start of the year. The rate on a 30-year fixed-rate mortgage averaged 5.1% for the week ending last Thursday, according to Freddie Mac, touching its highest level in more than a decade.
The Fed’s decisions “will quickly make it harder to finance expensive purchases.” Jonathan Smoke, chief economist at Cox Automotive, wrote in a research note after the meeting. “That’s exactly what the Fed wants to see. As demand for homes, cars and other durable goods declines in response to declining affordability, the rate of price increases should also slow.
This slowdown in inflation would occur as fewer purchases and higher financing costs translate into slower business expansion. As companies hire less and the demand for workers declines, wage growth will slow, further slowing demand and helping to depress prices.
“You can see the labor market is out of balance: you can see there’s a labor shortage,” Powell said. “We need to get back to price stability so we can have a labor market where people’s wages aren’t eaten away by inflation, and where we can also have a long expansion.”