Another month, another huge interest rate hike.
The Federal Reserve raised its key short-term rate by three-quarters of a percentage point for the second consecutive month on Wednesday in an effort to contain soaring inflation, matching the largest 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 neutral rate of 2, 5% of the Fed. This is the rate that is intended not to stimulate or limit economic growth.
In recent months, Fed Chairman Jerome Powell has said that the central bank must “move quickly” to that neutral level and then likely beyond to cool the economy and keep inflation in check.
The big question: Will the Fed now reduce the size of its rate hikes for the rest of the year?
“We could make another unusually large hike, but it’s not a decision we’ve made,” 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 early to tell if the economy will slow enough. Recent increases have been so large and rapid that the economy probably hasn’t felt the full impact yet, he said.
“We think demand is moderating. How much is it moderating? We’re not sure, “she said.” We’ll have to look carefully at the data. “
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” as the rate increases to gauge its effect on the economy.
Both Goldman Sachs and Barclays expect the central bank to approve a half-point rate hike in September before reverting to more traditional quarter-point moves in November and December. This would leave the rate from 3.25% to 3.5% at the end of the year, in line with the median forecasts by Fed officials.
But they say Powell will likely avoid sending strong signals to keep Fed options open for a half to three-quarter point move in six weeks.
“With inflation set to fall and growing signs of economic weakness, we suspect officials will hike rates more cautiously from here,” to a half-point move in September, Capital Economics economist Michael Pearce wrote. in a research note.
The effect of the Fed rate hike on the economy
Wednesday’s rate hike is expected to spread across the economy, pushing up rates for credit cards, home equity lines of credit and other loans significantly. 30-year fixed mortgage rates jumped to an average of 5.54% from 3.22% earlier this year. At the same time, households, especially the elderly, are finally enjoying higher bank returns after years of poor returns.
While recent spending and output indicators have eased, job gains have been robust in recent months and the unemployment rate has remained low, the Fed said in a statement following a two-day meeting. Inflation remains high due to the pandemic, rising food and energy prices, and a broader price hike, he added.
“The committee is strongly committed to bringing inflation back to its 2% target,” the Fed said in its announcement.
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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 recession.
Shares rose after Powell said the Fed’s priority is to reduce inflation, but acknowledged that this would cause the unemployment rate to rise. The Dow Jones Industrial Average closed up 436 points, or 1.4%. Meanwhile, the S&P 500 closed up 103 points, or 2.6%. The Nasdaq Composite posted the largest gains on Wednesday. It closed 470 points higher, or 4%.
Treasury bond yields fell with the 10-year to 2.783% and the one-year to 3.015%.
How does rising interest rates fight inflation?
The Fed had no choice but to approve a second three-quarter point move, economists say, after annual inflation hit a new 40-year high of 9.1% in June, according to the price index. to consumption (CPI). Additionally, employers added 372,000 jobs last month.
And there are signs that inflation is poised to go down in the second half of the year. Oil prices have fallen sharply since mid-June, pushing gas prices lower, and other commodity costs, including wheat, corn and copper, have also plummeted on fears of a global recession.
Meanwhile, the supply chain bottlenecks that triggered the product shortage are easing. The dollar strengthened, cutting the price of imported goods. And retailers are stuck with bloated inventory after ordering too many products to address supply issues. This means that big discounts are likely.
What will happen if the economy slows down?
Evidence of an economic slowdown is already emerging. Initial jobless claims – an indicator of layoffs – recently peaked in eight months. Housing sales plummeted 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 Thursday that the nation’s gross domestic production declined for the second consecutive quarter in the three months ending June. While some economists see this as an informal signal of a recession, the National Bureau of Economic Research, the nonprofit group that calls the downturns, relies on a broader definition that includes a “significant decline in economic activity,” in particularly the hires.
Powell said too many sectors, particularly the labor market, are performing well for the economy to be in recession.
Goldman Sachs expects the economy to grow only about 1% this year after a 5.7% increase in 2021, which was its highest since 1984.
With the Fed’s key rate approaching neutral, officials are likely to begin to focus more on the recession risks favored by its rate hikes, Barclays says.
“We expect the bar for aggressive hikes to rise” during the second half of the year, the research company says.
Yet economist Kathy Bostjancic of Oxford Economics believes the Fed will remain in the fight against inflation with its bare hands until it sees that the Powell threshold has been reached “clear and compelling evidence” that price pressures are building. loosening, not just signs of a potential decline. She expects another three-quarter point Fed hike in September.
Barclays expects annual inflation to drop to 5.7% by December, according to the CPI, down significantly but still well above the Fed’s 2% target.
PCE vs CPI inflation
While the public mainly sees inflation rising and falling through the CPI, or Consumer Price Index, the Fed has long preferred the Personal Consumer Expenditure Price Index (PCE) to measure inflation.
“It’s just better to capture the inflation that people actually face in their lives,” Powell said.
The annual increase in the PCE index was 6.3% in May, compared to 8.6% for the CPI.
Although the two measures tend to merge over time, the CPI has a greater weight on food, gas, cars and housing than the PCE index, he said.
“So, we’re going to look at both of them,” he said. “But again, what we think is the best measure has always been the PCE.”
Contributors: Elisabeth Buchwald