The US Federal Reserve is expected to accelerate its monetary policy tightening this week with its first half-percentage point rise since 2000 and signal more aggressive action to come until there is clear evidence that red-hot inflation is under control.
Mounting inflationary pressures stemming from a tight labour market coupled with price increases extending beyond the sectors most sensitive to pandemic-related shocks and the war in Ukraine have compelled the Fed to speed up its withdrawal of stimulus, or risk falling further out of step.
Federal Open Market Committee officials will convene on Tuesday for a two-day policy gathering, at which they are expected to raise rates for the second meeting in a row and formalise plans to shrink the Fed’s $9tn balance sheet.
The central bank’s rhetoric has shifted notably since March, when it delivered its first interest rate increase since 2018, bringing the target range of the federal funds rate from near-zero to between 0.25 and 0.50 per cent.
Since that meeting, Jay Powell, chair, has pledged the Fed will “expeditiously” move its benchmark policy rate closer to a “neutral” level that no longer supports demand. That is likely to translate into multiple half-point rate rises in the coming months, which would lift the fed funds rate to about 2.5 per cent by the end of this year.
Estimates of “neutral” vary. Fed officials have pegged it between 2 and 3 per cent, although many economists think it is higher given the current level of inflation.
The Fed is “playing catch-up . . . they wish they had started earlier and so could have moved more gradually, but they didn’t”, said Randall Kroszner, who served as a Fed governor between 2006 and 2009. “If they don’t act boldly and speak about acting boldly now, the risk of inflation expectations becoming unanchored increases significantly.”
Financial markets have adjusted rapidly, with borrowing costs across a number of metrics dramatically higher than just a few weeks ago.
The benchmark 10-year Treasury yield breached 3 per cent on Tuesday, having just reached 2 per cent in February. That is the highest level in four years and the fastest rise of that magnitude since late 2010. Equity markets have also come under pressure, with the technology-heavy Nasdaq Composite registering in April its worst monthly performance since 2008.
To augment its tightening efforts, the Fed will also soon begin reducing its holdings of Treasuries and agency mortgage-backed securities, which swelled over the past two years as the central bank propped up financial markets and the economy.
The Fed will make official on Wednesday its plans to shed up to $95bn of assets a month — split between $60bn in Treasuries and $35bn in agency mortgage-backed securities. The process is likely to start in June.
Taken together, the next few policy meetings constitute the “front-loading” phase for the Fed, said Allison Boxer, an economist at Pimco, as it seeks to reverse the largesse provided during the pandemic.
She reckoned the earliest the Fed can return to quarter-point rate rises is September, particularly after Russia’s invasion of Ukraine fuelled the inflation surge. Some traders have speculated the central bank may boost the size of its rate increases and implement a 0.75 percentage point adjustment at some point, something it has not done since 1994.
Uncertainty about how high the Fed will need to raise interest rates to push inflation back towards its 2 per cent target is also complicating the outlook. Core inflation, as measured by the personal consumption expenditures price index, now hovers at 5.2 per cent from a year ago.
“I don’t think one can assert with any confidence that we know where the end point is for rate increases,” said Jeremy Stein, a Harvard academic who was nominated by the Obama administration alongside Powell to serve on the Fed’s board of governors in 2011. “You can say we’re going to do what it takes, but it’s hard to know at this stage what it will take.”
“There’s a fair amount of prayer involved,” he quipped.
James Bullard, a voting member of the FOMC this year and one of its biggest hawks, said last month that it is a “fantasy” to think the Fed can bring inflation down far enough without lifting rates to a level that actively constrains economic activity.
“Neutral is not putting downward pressure on inflation. It’s just ceasing to put upward pressure on inflation,” he said, noting his support for the fed funds rate to be 3 percentage points higher by the third quarter.
Given the Fed’s spotty record in successfully engineering a “soft landing” without causing undue economic pain, economists are concerned about an impending recession and job losses.
While officials have been optimistic they can avoid that outcome, they have also acknowledged the challenge ahead. Investors on Wednesday will be looking for any sign Powell’s confidence is waning.
“The Fed is not operating with a scalpel but more with a hatchet in terms of how it is affecting the economy as policy becomes less accommodative and eventually restrictive,” said Peter Hooper, the global head of economic research at Deutsche Bank, who worked at the Fed for almost three decades. “I just don’t see any way around unemployment needing to go up because of this process.”
Additional reporting by Kate Duguid in New York