Fed Downshifts Inflation Fight With Quarter-Point Rate Hike

The Fed wants to see more progress before pivoting to rate cuts

Chairman Jerome Powell Holds A Press Conference At The Federal Reserve

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Key Takeaways

  • As widely expected, the Fed hiked its benchmark interest rate a quarter-point, its smallest since March.
  • Recent signs of fading inflation were not enough to persuade the central bank to pause or reverse its campaign of rate hikes, although officials did acknowledge progress.
  • The Fed's rate hikes have so far slowed the economy and dampened inflation without increasing unemployment, going by official measures of the labor market.

The Federal Reserve raised its benchmark interest rate a quarter of a percentage point Wednesday, marking a further deceleration in the central bank’s war on inflation. 

It was the Fed’s smallest rate hike since March, when it began its campaign to quell rampant and widespread price increases by raising borrowing costs throughout the economy. The size of the latest bump to the fed funds rate was the smallest one possible since the Fed moves in quarter-point increments and was widely expected. The hike brings the fed funds rate to a range of 4.5% to 4.75%, its highest since September 2007 just before the Great Recession. 

Wednesday’s action moves the Fed closer to ending its current rate hike cycle. Fed officials acknowledged that they’ve made progress against inflation, but once again said they would likely raise interest rates again at future meetings.

“My colleagues and I understand the hardship that high inflation is causing, and we are strongly committed to bringing inflation back down to our 2% goal,” Fed Chair Jerome Powell said at a press conference. “Over the past year, we've taken forceful actions to tighten the stance of monetary policy. We've covered a lot of ground and the full effects of our rapid tightening so far are yet to be felt. Even so, we have more work to do.”

Stocks rose after Powell’s press conference comments, which analysts viewed as “dovish,” while the yield on the 10-year Treasury retreated.

The War on Inflation, and Its Casualties

Experts expect the central bank to pivot from inflation-fighting mode to economic stimulus mode later this year. Participants in the Federal Open Market Committee projected in December that they would have to raise the rate to the 5%-5.25% range—equal to two additional quarter-point rate hikes after Wednesday’s—before beginning to back off. The Fed’s campaign of interest rate hikes is meant to combat inflation by making it costlier to borrow money, discouraging businesses and individuals from spending, and giving supply and demand a chance to rebalance.

The rate hikes have been harsh medicine for household finances and the broader economy. Consumers have paid higher interest rates on loans directly tied to the fed funds rate, such as car notes and credit cards. Mortgage rates, which are indirectly influenced by fed funds rate movements, soared last year, pushing homebuying affordability to record lows and crushing the residential real estate market (although both have begun to improve recently).

Consumer spending, the engine of the country’s economic growth, has started to fizzle. And while official measures of the job market are still healthy, with the unemployment rate hovering around 3.5%, close to a record low, the slowing economy has caused cracks to appear in the labor outlook. Major companies such as Google, Microsoft, and Amazon have laid off workers by the tens of thousands in the last month as the economic outlook has soured. 

The Fed faces a difficult balancing act when managing interest rates. Policymakers aim to slow economic growth enough to subdue cost-of-living increases that have been painful for consumers—especially those with lower incomes. But dragging the economy down too much can result in a recession, which would bring its own brand of misery in the form of job losses. Many economists expect the economy to sink into a moderate recession this year, if one hasn’t started already

Throughout 2022, Fed officials were focused on crushing inflation, and tried to bludgeon it into submission with a series of outsized rate hikes. Indeed, inflation has cooled in recent months. Core PCE inflation, the Fed’s preferred measure of consumer price trends, peaked at 5.4% year-over-year last February and had simmered down to 4.4% as of December, inching closer to the Fed’s 2% target. The slowdown was more dramatic if measured by the annualized three-month moving average, which is quicker to show the improvement when inflation is falling. 

Powell noted the progress but said he wasn’t convinced that inflation was in check just yet. 

“While recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path,” Powell said.

As inflation has diminished, the threat of recession has loomed. The economy had nearly a 50-50 chance of entering a recession within the next year, up from 12% in January 2022, according to a recession probability tracker by the Federal Reserve Bank of New York, which analyzes yield curve data to compute recession chances. 

The Fed expects to halt the spate of hikes at some point and eventually reverse course and cut interest rates to stimulate the economy, either to avert a recession—the so-called “soft landing” from an inflationary episode—or to lessen the damage of one. The timing of the pivot will depend on how inflation and the labor market respond to past rate hikes. Given the worsening economic outlook, the Fed will start cutting interest rates in the third quarter of 2023, economists at ING predicted.

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