Another month, another outrageous rise in interest rates.
The Federal Reserve raised its short-term policy rate by three-quarters of a percentage point for a second consecutive month on Wednesday in a bid to contain soaring inflation, the biggest increase since 1994.
It puts the federal funds rate – which is what banks charge each other for overnight loans – in a range of 2.25% to 2.5%, close to the long-term or neutral rate of 2.5 % Fed. This is the rate intended to neither stimulate nor hinder economic growth.
In recent months, Fed Chairman Jerome Powell has said the central bank needs to “move quickly” to that neutral level and then likely beyond it to cool the economy and get inflation under control.
The big question: Will the Fed now reduce the magnitude of its stock market depreciation rate hikes for the rest of the year?
Understanding Fed rate hikes:Why is the Fed raising interest rates? And how do these hikes slow down inflation?
Answers to your questions:With the next Fed interest rate hike due this week, we answer your top financial questions
Will the Fed continue to raise rates?
Powell could provide clues at a 2:30 p.m. press conference. Both Goldman Sachs and Barclays expect the central bank to approve a half-point rate hike in September before returning to more traditional quarter-point moves in November and December. That would leave the rate at 3.25% to 3.5% at the end of the year, in line with the median forecast by Fed officials.
But they say Powell will likely avoid sending strong signals to keep Fed options open for a half or three-quarter point move in six weeks.
Impact of Fed rate hike
Wednesday’s rise is expected to ripple through the economy, sending rates sharply higher on credit cards, home equity lines of credit and other loans. 30-year fixed mortgage rates have climbed to an average of 5.54% from 3.22% at the start of this year. At the same time, households, especially seniors, are finally enjoying higher returns from bank savings after years of meager returns.
While recent spending and output indicators have weakened, jobs gains have been robust in recent months and the unemployment rate has remained low, the Fed said in a statement after a two-day meeting. Inflation remains high, due to the pandemic, rising food and energy prices and broader price hikes, he added.
“The committee is firmly committed to bringing inflation back to its 2% target,” the Fed said in its announcement.
Credit is more expensive:The Fed is poised for another big interest rate hike. That’s what it means to you.
To put the Fed’s aggressive rate hike campaign into perspective, the fed funds rate was close to zero at the start of the year – a legacy of its efforts to propel the nation out of the COVID-19-induced downturn.
Stocks held steady after the Fed’s decision. The Dow Jones Industrial Average rose 129 points, or 0.4% PM EST. The S&P 500 gained 60 points, or 1.59%. The Nasdaq Composite rose 334 points or 2.9%
Treasury yields jumped, with the 10-year rising to 2.756% and the 1-year to 3.065%
How do rising interest rates slow down inflation?
The Fed had no choice but to approve a second three-quarter point move on Wednesday, economists said, after annual inflation hit a new 40-year high of 9.1% in June, according to the consumer price index (CPI). Additionally, U.S. employers added 372,000 jobs last month, underscoring a still buoyant labor market despite Fed rate hikes aimed at tempering gains to dampen wage growth.
Economists, in fact, speculated that a full one percentage point rate hike at this week’s meeting was on the table. But those talks died down after a closely watched measure of consumers’ long-term inflation expectations – which can affect actual price increases – eased considerably to 2.8% in July, according to a survey by the University of Michigan.
Additionally, there are signs that inflation is about to ease in the second half of the year. Oil prices have fallen sharply since mid-June, leading to lower gasoline prices, and the costs of other commodities, including wheat, corn and copper, have also fallen on fears of global recession.
Meanwhile, the supply chain bottlenecks that triggered product shortages are easing. The dollar strengthened, reducing the price of imported goods. And retailers are stuck with bloated inventory after ordering too many products to deal with supply issues. This means that heavy discounts are likely.
What will happen if the economy slows down?
Evidence of a slowing economy is already emerging. Initial jobless claims – a measure of layoffs – recently hit an eight-month high. Home sales fell due to rising mortgage rates. And while retail sales rose solidly last month, they fell after adjusting for inflation, says Gregory Daco, chief economist at EY Parthenon.
The government could report on Thursday that the country’s gross domestic output fell for a second straight quarter in the three months to June. While some economists view this as an informal signal of recession, the nonprofit group calling the downturns relies on a broader definition that includes a “significant decline in economic activity,” particularly hiring.
Goldman Sachs expects the economy to grow only about 1% this year after rising 5.7% in 2021, the highest since 1984.
With the Fed’s key rate nearing neutral, officials should begin to focus more on the recession risks fostered by its rate hikes, Barclays said.
“We expect the bar for aggressive bulls to get higher” in the second half of the year, the research firm said.
Yet economist Kathy Bostjancic of Oxford Economics believes the Fed will remain in bare-knuckle inflation-fighting mode until it sees Powell’s threshold has been reached – “clear and compelling evidence “that price pressures are easing, not just signs of a potential downside.” She predicts another three-quarter point hike from the Fed in September.
The Fed was forced into its hardline strategy because it underestimated the resilience of inflation for most of last year, believing that price increases would subside as economic problems supply would be resolved and consumer demand driven by the reopening of the economy would return to normal. This narrative has been disrupted, in part, by Russia’s invasion of Ukraine and the lingering effects of the pandemic on labor shortages.
Barclays expects annual inflation to fall to 5.7% by December, down significantly but still well above the Fed’s 2% target.