The Federal Reserve intensified its fight against the worst inflation in 40 years by raising its benchmark short-term interest rate by a half-percentage point Wednesday — its most aggressive move since 2000 — and signalling further large rate hikes to come.
The increase in the Fed's key rate raised it to a range of 0.75 per cent to 1 per cent, the highest point since the pandemic struck two years ago.
The Fed also announced that it will start reducing its huge US$9 trillion ($13.8t) balance sheet, which consists mainly of Treasury and mortgage bonds. Those holdings more than doubled after the pandemic recession hit as the Fed bought trillions in bonds to try to hold down long-term borrowing rates. Reducing the Fed's holdings will have the effect of further raising loan costs throughout the economy.
All told, the Fed's credit tightening will likely mean higher loan rates for many consumers and businesses over time, including for mortgages, credit cards and auto loans.
Speaking at a news conference Wednesday, Chair Jerome Powell made clear that further large rate hikes are coming.
"There is a broad sense on the committee," he said, referring to the Fed, "that additional (half-point) increases should be on the table in the next couple of meetings."
But Powell also sought to downplay any speculation that the Fed might be considering a rate hike as high as three-quarters of a percentage point.
"A 75-basis-point hike is not something that the committee is actively considering," he said — a remark that appeared to cause stock indexes to rise.
With prices for food, energy and consumer goods accelerating, the Fed's goal is to cool spending — and economic growth — by making it more expensive for individuals and businesses to borrow. The central bank hopes that higher borrowing costs will slow spending enough to tame inflation yet not so much as to cause a recession.
It will be a delicate balancing act. The Fed has endured widespread criticism that it was too slow to start tightening credit, and many economists are sceptical that it can avoid causing a recession.
At his news conference, Powell stressed his belief that "restoring price stability" — that is, curbing high inflation — is essential to sustaining the economy's health.
In their statement Wednesday, the central bank's policymakers noted that Russia's invasion of Ukraine is worsening inflation pressures by raising oil and food prices. It added that "Covid-related lockdowns in China are likely to exacerbate supply chain disruptions," which could further boost inflation.
Inflation, according to the Fed's preferred gauge, reached 6.6 per cent last month, the highest point in four decades. Inflation has been accelerated by a combination of robust consumer spending, chronic supply bottlenecks and sharply higher gas and food prices, exacerbated by Russia's war against Ukraine.
Starting June 1, the Fed said it would allow up to US$48 billion in bonds to mature without replacing them, a pace that would reach US$95b by September. At September's pace, its balance sheet would shrink by about US$1t a year.
Powell has said he wants to quickly raise the Fed's rate to a level that neither stimulates nor restrains economic growth. Fed officials have suggested that they will reach that point, which the Fed says is about 2.4 per cent, by year's end.
The Fed's credit tightening is already having some effect on the economy. Sales of existing homes sank 2.7 per cent from February to March, reflecting a surge in mortgage rates related, in part, to the Fed's planned rate hikes. The average rate on a 30-year mortgage has jumped 2 percentage points just since the start of the year, to 5.1 per cent.
Yet by most measures, the overall economy remains healthy. This is especially true of the US job market: Hiring is strong, layoffs are few, unemployment is near a five-decade low and the number of job openings has reached a record high.
Powell has pointed to the widespread availability of jobs as evidence that the labour market is tight – "to an unhealthy level" that would tend to fuel inflation. The Fed chair is betting that higher rates can reduce those openings, which would presumably slow wage increases and ease inflationary pressures, without triggering mass layoffs.
For now, with hiring robust — the economy has added at least 400,000 jobs for 11 straight months — and employers grappling with labour shortages, wages are rising at a roughly 5 per cent annual pace. Those pay raises are driving steady consumer spending despite spiking prices. In March, consumers increased their spending 0.2 per cent even after adjusting for inflation.
Even if the Fed's benchmark rate were to go as high as 2.5 per cent by year's end, Powell said last month, the policymakers may still tighten credit further — to a level that would restrain growth — "if that turns out to be appropriate."
Financial markets are pricing in a rate as high as 3.6 per cent by mid-2023, which would be the highest in 15 years. Shrinking the Fed's balance sheet will add another layer of uncertainty surrounding how much the Fed's actions may weaken the economy.
Complicating the Fed's task is a slowdown in global growth. Covid-19 lockdowns in China are threatening to cause a recession in the world's second-largest economy. And the European Union is facing higher energy prices and supply chain disruptions after Russia's invasion of Ukraine.
What's more, other central banks around the world are also raising rates, a trend that could further imperil global growth. On Thursday, the Bank of England is expected to raise its key rate for the fourth straight time. The Reserve Bank of Australia increased its rate Tuesday for the first time in 11 years.
And the European Central Bank, which is grappling with slower growth than in the United States or the United Kingdom, may raise rates in July, economists expect.