WASHINGTON — The Federal Reserve is set to accelerate its most drastic measures in three decades to fight inflation this week by making it more expensive to borrow — for a car, a house, a business deal, a purchase by credit card – all of this will aggravate Americans’ financial stress and likely weaken the economy.
Yet with inflation at a 40-year high, the Fed has come under extraordinary pressure to act aggressively to slow spending and rein in the price spikes plaguing households and businesses.
After its last rate-setting meeting ends on Wednesday, the Fed will almost certainly announce that it is raising its benchmark short-term interest rate by half a percentage point — the biggest rate hike since 2000. The Fed will likely make another half-point rate hike at its next meeting in June and possibly the next one in July. Economists are predicting further rate hikes in the coming months.
Additionally, the Fed is also expected to announce on Wednesday that it will begin rapidly reducing its large stockpile of Treasuries and mortgage bonds starting in June – a move that will further tighten credit.
Chairman Jerome Powell and the Fed will take these actions largely in the dark. No one knows how far the central bank’s short-term interest rate should go to slow the economy and contain inflation. Officials also don’t know how much they can reduce the Fed’s unprecedented $9 trillion balance sheet before they risk destabilizing financial markets.
“I liken it to driving in reverse while using the rear view mirror,” said Diane Swonk, chief economist at consultancy Grant Thornton. “They just don’t know what obstacles they’re going to encounter.”
Yet many economists believe the Fed is already acting too late. Even though inflation has soared, the Fed’s benchmark rate is in a range of just 0.25% to 0.5%, a level low enough to spur growth. Adjusted for inflation, the Fed’s key rate, which influences many consumer and business loans, is deep in negative territory.
That’s why Powell and other Fed officials have said in recent weeks that they want to raise rates. “rapidly”, at a level that neither stimulates nor hinders the economy – what economists call the “neutral” rate. Policymakers consider a neutral rate to be around 2.4%. But no one is sure what the neutral rate is at any given time, especially in a rapidly changing economy.
If, as most economists expect, the Fed makes three half-point rate hikes this year and then three quarter-point hikes, its rate will hit roughly neutral by the end of the year. Those increases would represent the fastest pace of rate hikes since 1989, noted Roberto Perli, an economist at Piper Sandler.
Even dovish Fed officials like Charles Evans, president of the Federal Reserve Bank of Chicago, endorsed this course. (fed “doves” generally prefer to keep rates low to support hiring, while “hawks” often support higher rates to curb inflation.)
Powell said last week that once the Fed hits its neutral rate, then it could tighten credit even further – to a level that would dampen growth – “if that proves appropriate.” Financial markets are forecasting a rate as high as 3.6% by mid-2023, which would be the highest in 15 years.
Expectations for the Fed’s path have become clearer in recent months as inflation has intensified. That’s a stark change from just a few months ago: After the Fed meeting in January, Powell said, “It is not possible to predict with much confidence exactly which trajectory for our policy rate will turn out to be appropriate.”
Jon Steinsson, an economics professor at the University of California, Berkeley, thinks the Fed should provide more formal guidance, given how quickly the economy is changing in the aftermath of the pandemic recession and war of Russia against Ukraine, which has exacerbated supply shortages across the world. The Fed’s most recent official forecast in March called for rate hikes of seven quarter points this year – a pace that is already hopelessly overshot.
Steinsson, who in early January had called for a quarter-point increase at every meeting this year, said last week, “Things need to be done quickly to send the signal that a sizeable tightening is needed.”
One of the challenges facing the Fed is that the neutral rate is even more uncertain now than usual. When the Fed’s key rate hit 2.25% to 2.5% in 2018, it triggered a drop in home sales and financial markets fell. The Fed Powell reacted by doing an about-face: it cut rates three times in 2019. This experience suggested that the neutral rate could be lower than the Fed thinks.
But given that prices have since spiked, cutting inflation-adjusted interest rates, whatever Fed rate actually slows growth could be well above 2.4%.
The reduction in the Fed’s balance sheet adds further uncertainty. This is especially true given that the Fed is expected to drop $95 billion worth of securities each month as they mature. That’s nearly double the $50 billion pace it was maintaining before the pandemic, the last time it reduced its bond holdings.
“Turning two knobs at the same time makes things a bit more complicated”, said Ellen Gaske, chief economist at PGIM Fixed Income.
Brett Ryan, an economist at Deutsche Bank, said the balance sheet reduction would roughly amount to increases of three-quarters of a point through next year. Added to expected rate hikes, this would translate into a tightening of around 4 percentage points through 2023. Such a dramatic increase in borrowing costs would send the economy into recession by the end of next year. , according to Deutsche Bank forecasts.
Yet Powell is counting on the robust job market and solid consumer spending to spare the United States such a fate. Although the economy contracted in the January-March quarter at an annual rate of 1.4%, businesses and consumers increased their spending at a healthy pace.
If sustained, this spending could keep the economy expanding in the coming months and perhaps beyond.