Federal Reserve officials say they will take an aggressive approach to combating high inflation in the coming months – actions that will make lending much more expensive for consumers and businesses and increase risks to the economy.
Minutes after their March policy meeting on Wednesday, Fed officials said raising interest rates by half a unit, instead of the traditional quarterly increases, “could be appropriate” several times this year.
At last month’s meeting, many Fed policymakers favored a half-point increase, the minutes said, but were later postponed due to uncertainty over Russia’s invasion of Ukraine. Instead, the Fed raised its key short-term interest rate by a quarter and indicated it plans to continue raising interest rates next year.
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Minutes also show that the Fed is also moving towards a rapid contraction in its huge $ 9 trillion bond stock in the coming months, a move that will contribute to higher borrowing costs. Policymakers said they would likely cut those contributions by about $ 95 billion a month – almost double the rate they set five years ago when they last shrunk their balance sheets.
The plan to quickly pull out their bonds marks the latest move by Fed officials to step up their efforts to fight inflation. Prices are rising at the fastest pace in four decades and officials have expressed growing concern about inflation.
The Fed’s plans “reflect their deep displeasure with the rapid pace of inflation,” said Kathy Bostjancic, chief US financial economist at Oxford Economics.
The Fed is “increasingly concerned” that consumers and businesses will begin to expect price increases to continue, Bostjancic added, a trend that could in itself prolong high inflation.
Many economists said they were concerned that the Fed was waiting too long to start raising interest rates and that it might be forced to react so aggressively as to cause a recession. Indeed, Deutsche Bank economists predict that the economy will fall into recession at the end of next year, noting that the Fed, “finding itself far behind the curve, has given clear signals that it is moving into a more aggressive tightening situation.”
The stock market sold out when the minutes were released, but later recovered from its worst levels. However, the S&P 500 closed almost 1% after falling sharply on Tuesday.
Markets are now expecting much sharper interest rate hikes this year than Fed officials only signaled at their recent meeting in mid-March. At that meeting, policymakers predicted that the benchmark interest rate would remain below 2% until the end of this year and 2.8% at the end of 2023, from its current level below 0.5%. . But Wall Street now predicts that the Fed’s interest rate will reach 2.6% by the end of the year, with further increases next year.
Higher Fed interest rates, in turn, will increase the cost of mortgages, car loans, credit cards and corporate loans. In doing so, the Fed hopes to slow economic growth and raise wages enough to tackle high inflation, which has plagued millions of households and posed a serious political threat to President Joe Biden.
President Jerome Powell opened the door two weeks ago to raising interest rates by up to half a point. Lael Brainard, a key member of the Fed’s Board of Directors, and other officials have also made it clear that they envision such sharp increases. Most economists now expect the Fed to raise interest rates by half a point in May and June.
In a speech Tuesday, Brainard underlined the Fed’s growing aggression, saying its bonds would “shrink significantly faster” in “a much shorter period” than the last time it cut its balance sheet, from 2017-2019. The balance sheet was about $ 4.5 trillion. Now, it doubles.
Federal Reserve Chairman Jerome Powell received questions from lawmakers Wednesday.
After the pandemic hit the economy two years ago, the Fed bought trillions in government bonds and mortgages to cut long-term lending rates. It also reduced the short-term reference rate to almost zero.
As a sign of how quickly the Fed is reversing its course, the last time the Fed bought bonds, there was a three-year gap between when it stopped buying in 2014 and when it started cutting its balance sheet in 2017. Now, this shift is likely to occur in three months or less, with the balance sheet reduction likely to be announced as early as May.
Brainard’s remarks caused a sharp rise in the interest rate on the 10-year government bond, which affects mortgage rates, business loans and other borrowing costs. On Wednesday, this percentage reached 2.6%, from 2.3% a week earlier and 1.7% a month ago. Average mortgage rates have jumped higher, reaching 4.67% last week, according to mortgage buyer Freddie Mac, the highest since 2018.
Yields on short-term bonds have skyrocketed, in some cases above the 10-year yield, a pattern that is often taken as a sign of impending recession. Fed officials, however, say short-term bond market trends are not flashing the same warning signs.
Gennadiy Goldberg, senior strategic interest rate analyst at TD Securities, said the narrow gap between longer-term and short-term bond yields indicates that investors believe the economy will slow down enough over the next two years to force the Fed to cut its interest rate increases.
To shrink its balance sheet, the Fed will let some of its bonds mature without reinvesting revenue. What effect this may have is uncertain. Powell said last month that reducing available bonds would be tantamount to another rate hike. Economists estimate that a $ 1 trillion year-on-year reduction in the balance sheet would be tantamount to anywhere from one to three additional quarterly increases to the Fed’s short-term reference rate each year.
Finance Minister Janet Yellen, who preceded Powell as Fed chairman, suggested in a congressional hearing Wednesday that Russia’s invasion of Ukraine would likely continue to escalate inflation in the coming months.
“The sanctions we have imposed on Russia are raising the price of energy,” Yellen said. “When energy prices go up, the price of wheat and corn produced by Russia and Ukraine goes up and the metals that play an important role. The industrial role goes up.”