The era of COVID-19-induced low interest rates is over – just as the United States finally seems to be turning the corner on the pandemic.
Yet, as falling COVID-19 cases and strong consumer demand help pave the way for higher rates, the Federal Reserve is tackling the pandemic’s stubborn economic legacy: surging inflation.
In a bid to rein in a historic spike in consumer prices, the Fed raised its main short-term interest rate on Wednesday — by a quarter of a percentage point — for the first time in more than three years and plans six more hikes. This year. That’s more than the three total quarter-point increases that Fed officials predicted in December and more than the six moves that many top economists predicted this week. The Fed plans four more hikes in 2023.
The central bank also sharply raised its inflation forecast, largely in the wake of Russia’s attack on Ukraine, while lowering its estimate for economic growth, underscoring the dilemma facing the Fed as it unfolds. trying to control price increases without tipping the economy into recession.
“Russia’s invasion of Ukraine is causing enormous human and economic hardship,” the Fed said in a statement after a two-day meeting. “The implications for the U.S. economy are highly uncertain, but in the near term, the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”
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In a new video conference, Fed Chairman Jerome Powell said officials believe the economy can handle multiple rate hikes without slipping into recession.
“It’s clearly time to raise interest rates,” Powell said. “We believe the economy is very strong and well positioned to withstand” higher rates.
What do the Fed rate hikes mean?
Traditionally, the Fed raises rates to rein in borrowing, temper an overheated economy and fend off spikes in inflation. It reduces them to stimulate borrowing, economic activity and job growth. Today, it faces potentially the worst-case scenario of all worlds: spiraling inflation and slowing growth.
Wednesday’s hike pushes the federal funds rate — which is what banks charge each other for overnight loans — from near zero to a range of 0.25% to 0.5%. It is expected to ripple through the economy, pushing up rates on credit cards, home equity lines of credit and variable rate mortgages, among other loans. But Americans, especially seniors, should start getting some relief from low rates on savings accounts and CDs.
How did rising rates affect the stock market?
Immediately after the Fed’s announcement, stocks fell.
After trading higher ahead of the decision, the Dow Jones Industrials turned negative. The blue chip average hovered around 33,573 as of 2:15 p.m. ET. The S&P 500 and Nasdaq composite nearly erased its early-day gains.
The 10-year Treasury yield rose to 2.23% from 2.15%, where it opened Wednesday morning. This is the highest level of 10-year bond yields since May 2019.
Federal Bank of St. Louis chief James Bullard dissented, saying he preferred to raise the rate by half a point. In its statement, the central bank added that it expects “ongoing increases…will be appropriate.”
Although Powell told Congress last month he supported a quarter-point hike at the March meeting, economists debated the Fed’s aggressiveness in the coming months amid worrying economic conditions. .
“We expect to steadily raise interest rates,” he told reporters on Wednesday, adding that if the Fed were to move faster, “then we will.” This suggests that a half-point hike is possible at some meetings.
Will the Fed raise rates further in 2022 and beyond?
The Fed now expects its benchmark rate to hit 1.9% by the end of the year – above its pre-pandemic level – and 2.8% by the end of the year. of 2023, higher than predicted by many leading economists.
Since the fall, Fed policymakers have been preparing to battle a surge in inflation that has steadily hit new 40-year highs, with the consumer price index (CPI) rising 7.9% annually. in February.
Russia’s invasion of Ukraine last month compounded the problem by further increasing rapidly rising gasoline and food prices – Russia is one of the world’s largest oil producers – and exacerbating bottlenecks in the global supply chain. The average price for regular gasoline hit $4.32 a gallon on Tuesday, up from $3.50 just a month ago, according to AAA.
Labor shortages engendered by the pandemic are also fueling inflation by forcing employers to raise wages to attract a smaller pool of job applicants. This, in turn, incentivizes companies to raise prices to maintain profit margins.
Yet soaring prices are also dampening consumer spending, and the war in Ukraine is hitting the stock market and global growth, which is expected to slow the US economy.
How is the current US economy doing?
The Fed said Wednesday it expects the U.S. economy to grow 2.8% in 2022, down from its December estimate of 4%, according to officials’ median projections. This is still solid growth by historical standards, but analysts worry that an escalating war and sharp rate hikes could further slow the economy or even push it into recession.
The Fed estimates that its preferred annual inflation measure (which is different from the CPI) will end the year at 4.3% – well above its 2% target – before falling back to 2.7% in 2023, up from its previous forecast of 2.6% and 2.3%, respectively. It forecasts that a base measure that excludes volatile food and energy products will be 4.1% at the end of the year and 2.7% at the end of 2023, up from previous estimates of 2 .7% and 2.3%.
Fed officials still expect unemployment, now 3.8%, to fall to its pre-pandemic level of 3.5% – a 50-year low – by the end of this year and that it remains at that level by the end of 2023. This suggests that the Fed does not expect inflation or rising rates to derail the economy or the labor market.
What is the inflation rate for 2022?
Inflation is expected to moderate this year as the pandemic eases and more truckers, as well as factory, warehouse and port workers return to work, helping to ease supply issues . But the increase in the consumer price index should now peak in late spring at 8.7%, more than expected and it will take longer for inflation to subside, predicts economist Kathy Bostjancic from Oxford Economics.
Although Powell said the Fed believed it could raise rates to reduce inflation while maintaining a strong labor market, he made it clear that controlling inflation was the priority.
“The plan is to restore price stability,” he said, noting that there is a need to reduce long-term unemployment. “Price stability is a key objective.”
In an opinion piece published Tuesday in The Washington Post, Larry Summers, Treasury Secretary under President Obama, said the Fed had taken inflation too lightly over the past year and “should take a radically different direction” to “avoid stagflation (high inflation and stalled growth) and the associated loss of public confidence in our country now.
What other actions has the Fed taken?
The Fed also announced on Wednesday that it would begin trimming its billions of dollars in Treasuries and mortgage-backed securities “at an upcoming meeting” after initiating bond buying at the start of the pandemic. to lower long-term rates. The purchases swelled the Fed’s balance sheet to about $8.8 trillion.
Rather than selling bonds outright, which could disrupt markets, the Fed plans to gradually reduce its holdings by not reinvesting proceeds from certain assets as they mature. The shrinking balance sheet will also push up mortgage rates and other long-term rates.
Wednesday’s measures mark a reversal for a central bank that had been focused on helping the nation recover from the recession and the 22 million job losses caused by the pandemic. In March 2020, as the COVID-19 crisis shook the economy, the Fed cut its benchmark rate to near zero and initiated bond buying.
As recently as early November, Powell said officials believed the surge in inflation was transitory and would ease as supply problems and pent-up consumer demand from a reopening economy recede.
He said the Fed would be patient and refrain from raising rates so the economy can achieve full employment — an environment in which virtually everyone who wants a job has one.
But in late November, Powell acknowledged that supply issues and inflation would persist longer than expected. The United States still has 2.1 million jobs below its pre-pandemic level and the share of people over the age of 16 working or looking for work is 62.3%, in below the pre-crisis 63.4% mark. But many Americans retired early during the pandemic and most are not expected to return, and Powell said he believes the economy is at full employment.