The Federal Reserve takes off the gloves in its attempt to fight off a historic surge in inflation.
The Fed kept its key rate near zero on Wednesday, but said it would be “appropriate soon” to raise it, implying that a March rate hike is almost certain. The increase would be the first in more than three years and kick off what is expected to be a wave of increases of at least three-quarters points this year aimed at reining in sharply rising consumer prices.
Speculation over the widely expected move was a major reason for the stock market’s strong sell-off this month.
In a statement after a two-day meeting, the Fed did not say the economy had reached full employment, which would fulfill the central bank’s second condition for raising rates, but it did cite a “stock market hard work”. The Fed had previously said its other benchmark – inflation above 2% for “a while” – had been met.
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‘Soon appropriate’ to raise interest rates
“With inflation well above 2% and a strong labor market, the Committee expects it will soon be appropriate to raise ‘its key rate,'” the Fed said.
The central bank raises rates to rein in borrowing, temper an overheated economy, and avoid spikes in inflation, and lowers them to further stimulate borrowing, economic activity, and job growth.
A hike in the Fed’s key rate would drive up rates on mortgages, auto loans, credit cards and business loans, among other borrowing costs.
The Fed, which separately purchased trillions of dollars in Treasuries and mortgage-backed securities to lower long-term rates, also said it would wrap up those purchases in March, paving the way for rate hikes. rate.
The bond purchase swelled the Fed’s balance sheet to $8.8 trillion. The central bank said it had started discussing plans to reduce the portfolio, a move aimed at pushing up long-term rates.
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The economy continues to strengthen
Overall, the Fed described an economy that has “continued to strengthen” – presumably allowing it to get by with less central bank support – but which has recently been affected by the health crisis.
“Sectors hardest hit by the pandemic have improved in recent months but are impacted by the recent sharp increase in COVID-19 cases,” the Fed said, referring to the omicron variant.
Wednesday’s decisions mark a dramatic turnaround for a central bank that had been focused on helping the nation recover from the recession and the 22.4 million job losses caused by the pandemic. In March 2020, as the COVID crisis shook the economy, the Fed cut its benchmark rate to near zero and initiated bond buying. As recently as early November, Fed Chairman Jerome Powell told reporters that officials would be patient and refrain from raising rates so that the economy could reach full employment – an environment in which virtually everyone who wants a job has one.
Unemployment fell to 3.9% in December, not far above its pre-COVID level of 3.5%, a 50-year low. But payrolls are still 3.6 million workers below their pre-pandemic level. And millions of Americans are staying out of the workforce — the pool of people who are working and looking for jobs — because they fear COVID or struggle to find child care, change careers, or find jobs. living on stimulus checks or improved unemployment benefits.
Powell, however, recently said it will likely take longer than expected for Americans to return to the workforce and top economists say many, including millions of pre-retirees, never will. Reduced labor supply could prolong widespread labor shortages and drive up wages and inflation, providing another reason for the Fed to act quickly.
Skyrocketing inflation
Inflation hit a 40-year high of 7% in 2021, and Fed policymakers are feeling a growing sense of urgency to tame it. In the third quarter, wages and salaries rose at the fastest rate in two decades, raising fears of a wage-price spiral that could be difficult to contain.
For many months last year, Powell called the price spikes “transient” and traced them back to the pandemic and the reopening of the economy, with things like used cars, hotel rates and airfares bearing the brunt of the cost spiral.
But during a congressional hearing in late November, he acknowledged that rising prices were affecting a wider range of products and services and that the supply chain bottlenecks causing a large part of the advances could persist until 2022. Although higher interest rates cannot solve supply problems. , they may rein in strong consumer demand — fueled by federal stimulus checks and improved unemployment benefits — that have amplified product shortages and price gains.
Last month, the Fed accelerated the phasing out of its bond-buying stimulus package to pave the way for earlier and faster rate hikes. Powell said officials are unlikely to remove support for the economy by raising rates at the same time they add support by buying bonds,
How fast should the Fed raise rates?
The big question: how aggressively will the Fed raise rates?
In December, Fed officials forecast three rate hikes this year and three more in 2023, leaving the rate at 1.6% by the end of 2023, but fed funds futures markets expect four increases this year. Goldman Sachs economist David Mericle says there’s a chance the Fed will hike more than that, perhaps even at each of the seven remaining meetings in 2022, though he acknowledges that “few the Fed seem to be considering it right now.”
The Fed faces a delicate balancing act. Excessive rate hikes as growth slows — from around a booming 5.5% in 2021 to a still healthy 4% expected this year — could risk pushing the economy into another recession. And supply rumbles and wage increases are already expected to ease this year as COVID abates and more Americans return to work, posing the risk that the central bank will rise too much with inflation. already down.
Fed officials, however, have said there is also a risk that soaring inflation will derail the recovery – a danger they are trying to avoid.
At its meeting, the Fed’s policy-making committee also discussed plans to shrink its $8.8 trillion balance sheet, which has swelled due to bond purchases. Instead of selling bonds outright, which could disrupt markets, the Fed plans to gradually reduce holdings by not reinvesting proceeds from certain assets as they mature.
The Fed said it would begin to reduce the balance sheet after the rate hikes begin.
Goldman Sachs expects the Fed to begin trimming its portfolio in July and shrinking it to about $6.3 trillion over the next two years, which is equivalent to a rate hike of just over $100. a quarter point.
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