Another month, another outsize interest rate hike.
The Federal Reserve raised its key short-term rate by three-quarters of a percentage point for a second straight month Wednesday in a bid to corral soaring inflation, matching the largest increase since 1994.
It puts the federal funds rate – which is what banks charge one another for overnight loans – at a range of 2.25% to 2.5%, close to the Fed’s 2.5% long-run, or neutral rate. That’s the rate intended to neither stimulate nor curtail economic growth.
In recent months, Fed Chair Jerome Powell has said the central bank must “move expeditiously” to that neutral level and then likely beyond it to cool the economy and bring inflation under control.
The big question: Will the Fed now dial back the size of its rate increases for the rest of the year?
“We might do another unusually large increase, but that’s not a decision that we’ve made at all,” Powell said Wednesday.
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Will the Fed continue to raise rates?
Calling it an “extraordinarily challenging and uncertain time,” Powell said it’s too soon to say if the economy will slow enough. The recent increases have been so large and fast that the economy likely hasn’t felt the full impact yet, he said.
“We think that demand is moderating. How much is it moderating? We’re not sure,” he said. “We’re going to have to watch the data carefully.”
Yet he noted that now that the Fed’s key rate is at its long-run level, “at some point, it will be appropriate to slow down” the rate increases to assess their effect on the economy.
Goldman Sachs and Barclays both expect the central bank to approve a half-point rate increase in September before throttling back to more traditional quarter-point moves in November and December. That would leave the rate at 3.25% to 3.5% at year-end, in line with Fed officials’ median forecast.
But they say Powell will probably avoid sending strong signals to keep the Fed’s options open for a half- or three-quarters point move in six weeks.
“With inflation set to fall and mounting signs of economic weakness, we suspect officials will be more cautious raising rates from here,” shifting to a half-point move in September, economist Michael Pearce of Capital Economics wrote in a research note.
Fed rate hike’s effect on economy
Wednesday’s rate increase is expected to ripple through the economy, sharply pushing up rates for credit cards, home equity lines of credit and other loans. Fixed, 30-year mortgage rates have jumped to an average of 5.54% from 3.22% early this year. At the same time, households, especially seniors, are finally enjoying higher bank savings yields after years of meager returns.
While recent indicators of spending and production have softened, job 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 because of the pandemic, higher food and energy prices and broader price increases, it added.
“The committee is strongly committed to returning inflation to its 2% objective,” the Fed said in its announcement.
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To put the Fed’s aggressive rate hike campaign in perspective, the Fed funds rate was near zero at the start of the year – a legacy of its efforts to propel the nation from the COVID-19-induced downturn.
Stocks rose after Powell said the Fed’s priority is to get inflation down but acknowledged that it would cause the unemployment rate to rise. The Dow Jones Industrial Average closed 436 points higher, or 1.4%. Meanwhile the S&P 500 closed 103 points higher, or 2.6%. The Nasdaq Composite saw the biggest gains Wednesday. It closed 470 points higher, or 4%.
Yields on Treasury notes moved lower with the 10-year down to 2.783% and the one-year to 3.015%.
How does raising interest rates combat inflation?
The Fed had little choice but to approve a second three-quarters-point move, economists say, after annual inflation hit a new 40-year high of 9.1% in June, according to the consumer price index (CPI). Also, employers added 372,000 jobs last month.
And there are signs that inflation is poised to downshift in the second half of the year. Oil prices have fallen sharply since mid-June, pulling gas prices lower, and other commodity costs, including wheat, corn and copper, also have tumbled on global recession fears.
Meanwhile, supply chain bottlenecks that have triggered product shortages are easing. The dollar has strengthened, cutting the price of imported goods. And retailers are stuck with bloated inventories after ordering too many products to deal with the supply troubles. That means heavy discounts are likely.
What will happen if the economy slows?
Evidence of a slowing economy is already emerging. Initial jobless claims – a gauge of layoffs – recently hit an eight-month high. Housing sales have slumped amid higher mortgage rates. And while retail sales increased solidly last month, they declined after adjusting for inflation, says Gregory Daco, chief economist of EY Parthenon.
The government could report Thursday that the nation’s gross domestic output declined for a second straight quarter in the three months ending in June. While some economists view that as an informal signal of recession, the National Bureau of Economic Research, the nonprofit group that calls downturns, relies on a broader definition that includes a “significant decline in economic activity,” especially hiring.
Powell said too many sectors, particularly the job market, are performing strongly for the economy to be in a recession.
Goldman Sachs predicts the economy will grow only about 1% this year after a 5.7% surge in 2021, which was the most since 1984.
With the Fed’s key rate approaching the neutral level, officials are likely to start focusing more on the recession risks fostered by its rate increases, Barclays says.
“We expect the bar for aggressive hikes to become higher” through the second half of the year, the research firm says.
Yet economist Kathy Bostjancic of Oxford Economics believes the Fed will stay in bare-knuckled inflation-fighting mode until it sees that Powell’s threshold has been met “clear and compelling evidence” that price pressures are easing, not merely signs of a potential drop. She forecasts another three-quarters point Fed increase in September.
Barclays predicts annual inflation will fall to 5.7% by December, according to the CPI, down significantly but still well above the Fed’s 2% target.
PCE inflation vs. CPI
While the public primarily sees inflation rising and falling through the CPI, or Consumer Price Index, the Fed has long preferred the Personal Consumption Expenditures (PCE) price index to gauge inflation.
“It’s just better at capturing the inflation that people actually face in their lives,” Powell said.
The annual rise in the PCE index was 6.3% in May, compared to 8.6% for the CPI.
Although the two measures tend to come together over time, the CPI has higher weights on food, gas, cars and housing than the PCE index, he said.
“So, we’ll be watching both,” he said. “But again, the one that we think is the best measure always has been the PCE.”
Contributing: Elisabeth Buchwald
