Fed rate increase seen on horizon

Measures to take aim at inflation

WASHINGTON — The Federal Reserve is poised this week to accelerate its most drastic steps in three decades to attack inflation by making it costlier to borrow — for a car, a home, a business deal, a credit card purchase — all of which analysts say will compound Americans’ financial strains and likely weaken the economy.

Yet with inflation having surged to a 40-year high, the Fed has come under extraordinary pressure to act aggressively to slow spending and curb the price spikes that are bedeviling households and companies.

Analysts say that after the Fed’s latest rate-setting meeting ends Wednesday, it will likely announce that it’s raising its benchmark short-term interest rate by a half-percentage point — the sharpest rate increase since 2000. The Fed will likely carry out another half-point rate increase at its next meeting in June and possibly at the next one after that, in July. Economists foresee still further rate increases in the months to follow.

The Fed is also expected to announce Wednesday that it will begin quickly shrinking its stockpile of Treasury and mortgage bonds beginning in June — a move that will have the effect of further tightening credit.

Chairman Jerome Powell and the Fed will take these steps largely in the dark, economists say. No one knows just how high the central bank’s short-term rate must go to slow the economy and restrain inflation. Nor do the officials 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 rearview mirror,” said Diane Swonk, chief economist at the consulting firm Grant Thornton. “They just don’t know what obstacles they’re going to hit.”

Yet many economists think the Fed is already acting too late. Even as inflation has soared, the Fed’s benchmark rate is in a range of just 0.25% to 0.5%, a level low enough to stimulate growth. Adjusted for inflation, the Fed’s key rate — which influences many consumer and business loans — is deep in negative territory.

In crises, central banks that pause typically lose as the forces they’re battling — be it spreading financial panic or broadening inflation — gain more momentum.

“You don’t pause along the way” in an inflation fight, said Laurence Meyer, a former Fed governor who now runs policy analysis firm LH Meyer. “You do look around, but there is an urgency of moving beyond” a neutral rate of interest.

Powell and other Fed officials have said in recent weeks that they want to raise rates “expeditiously,” to a level that neither boosts nor restrains the economy — what economists refer to as the “neutral” rate. Policymakers consider a neutral rate to be roughly 2.4%. But no one is certain what the neutral rate is at any particular time, especially in an economy that is evolving quickly.

If, as most economists expect, the Fed this year carries out three half-point rate increases and then follows with three quarter-point jumps, its rate would reach roughly neutral by year’s end. Those increases would amount to the fastest pace of rate changes since 1989, noted Roberto Perli, an economist at Piper Sandler.

Even dovish Fed officials, such as Charles Evans, president of the Federal Reserve Bank of Chicago, have endorsed that path. (Fed “doves” typically prefer keeping rates low to support hiring, while “hawks” often support higher rates to curb inflation.)

Powell said last week that once the Fed reaches its neutral rate, it may then tighten credit even 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% by mid-2023, which would be the highest in 15 years.

Expectations for the Fed’s path have become clearer over just the past few months as inflation has intensified. That’s a sharp shift from just a few month ago: After the Fed met in January, Powell said, “It is not possible to predict with much confidence exactly what path for our policy rate is going to prove appropriate.”

Jon Steinsson, an economics professor at the University of California, Berkeley, said he thinks the Fed should provide more formal guidance, given how fast the economy is changing in the aftermath of the pandemic recession and Russia’s war against Ukraine, which has exacerbated supply shortages across the world. The Fed’s most recent formal forecast, in March, had projected seven quarter-point rate increases this year.

Steinsson, who in early January had called for a quarter- point increase at every meeting this year, said last week, “It is appropriate to do things fast to send the signal that a pretty significant amount of tightening is needed.”

One challenge the Fed faces is that the neutral rate is even more uncertain now than usual. When the Fed’s key rate reached 2.25% to 2.5% in 2018, it triggered a drop-off in home sales and financial markets fell. The Powell Fed responded by doing a U-turn: It cut rates three times in 2019. That experience suggested that the neutral rate might be lower than the Fed thinks.

But given how much prices have since spiked, thereby reducing inflation-adjusted interest rates, whatever Fed rate would actually slow growth might be far above 2.4%.

Shrinking the Fed’s balance sheet adds another uncertainty. That is particularly true given that the Fed is expected to let $95 billion of securities roll off each month as they mature. That’s nearly double the $50 billion pace it maintained before the pandemic, the last time it reduced its bond holdings.

“Turning two knobs at the same time does make it a bit more complicated,” said Ellen Gaske, lead economist at PGIM Fixed Income.

Brett Ryan, an economist at Deutsche Bank, said the balance-sheet reduction will be roughly equivalent to three quarter-point increases through next year. When added to the expected rate increases, that would translate into about 4 percentage points of tightening through 2023. Such a dramatic stepup in borrowing costs would send the economy into recession by late next year, Deutsche Bank forecasts.

Yet Powell is counting on the robust job market and solid consumer spending to spare the U. S. such a fate. Though the economy shrank in the January-March quarter by a 1.4% annual rate, businesses and consumers increased their spending at a solid pace.

If sustained, that spending could keep the economy expanding in the coming months and perhaps beyond.

While the Fed has raised rates just once this year, it’s easy to spot when markets really sat up and took notice that the central bank wasn’t kidding that it was about to tighten monetary policy. It was November 2021 when cryptocurrency and many of the riskiest stocks peaked.

“The stock market is forward looking, so just the expectation of higher rates has had an impact,” says Caleb Tucker, director of portfolio strategy at Merit Financial Advisors in the Atlanta area.

Still, the broad- based Standard & Poor’s 500 Index closed the year out near its all-time highs. From there, though, it’s been mostly downhill for the index, and more so for riskier investments. It’s been a similar situation for the Dow Jones Industrial Average and the Nasdaq Composite.

“From the beginning of 2022, stocks have pulled back and interest rates moved higher in anticipation of coming Federal Reserve interest rate hikes to corral inflation,” says Greg McBride, Bankrate chief financial analyst.

The S& P 500 is down about 12 % since the start of the year, while the tech-heavy Nasdaq Composite is down even more, 20%, and the Dow Jones Industrials are off 9% or so. Still-riskier investments have fared much worse, and the declines show few signs of slowing.

“Assets that have benefited most from ultra-low interest rates — think high- octane growth stocks with earnings well off into the future and non-cash-flow-generating assets like cryptocurrencies — have been most susceptible to a pullback given the prospect of higher interest rates,” says McBride.

For example, high-growth tech stocks such as Cloudflare and Carvana have fallen about 60% and 80%, respectively, from their 52-week highs just a few months ago.

Top cryptocurrency Bitcoin has fallen about 44% from its all-time high in November. The second-largest cryptocurrency Ethereum has seen a similar drop, down 42%.

“From the beginning of 2022, stocks have pulled back and interest rates moved higher in anticipation of coming Federal Reserve interest rate hikes to corral inflation.” —Greg McBride, Bankrate chief financial analyst.

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