Update 593 — Fed Hikes Rates 25 bps:
Brakes on Inflation, and Recovery Too?
After fostering and assisting economic recovery in manifold ways, the Fed is reversing course. Today, Fed Chairman Jerome Powell announced the Fed will be raising interest rates by 25 basis points (or 0.25 percentage points). This is the first rate hike since December 2018 and it casts almost as much of a macroeconomic cloud as the withdrawal of fiscal support, making a drop in GDP growth all but inevitable.
The Fed’s policy move comes at a time when the independent Fed is more politicized than ever. The Senate GOP has blocked a vote on all five of Biden’s Fed nominees. Sen. Manchin announced his opposition to Sarah Bloom Raskin’s candidacy for Fed Vice Chair of Supervision; yesterday, she withdrew it. Fed Board vacancy turbulence notwithstanding, the Fed’s inflation projections today aim at a soft landing, with inflation peaking this summer.
Below, we examine the Fed move and what that means for the economy, with an eye on the midterms.
Following the Federal Open Market Committee’s two-day March meeting ended today, the Federal Reserve is raising interest rates by 25 basis points. The move comes after months of deliberation and signaling from the Fed following a year of elevated inflation. It reflects calm and steady leadership the Fed has exercised throughout the pandemic and recovery, for which markets were thoroughly prepared. Now the task is to stay the course in order to tame inflation and avoid a recession.
No Surprises Today
Shocking no one, the FOMC agreed to raise interest rates by 25 basis points. Chair Pro Tempore Jerome Powell signaled this would occur during remarks to the House Financial Services Committee earlier this month. “With inflation well above 2 percent and a strong labor market, we expect it will be appropriate to raise the target range for the federal funds rate at our meeting,” Powell said. After further questioning from HFSC members, Powell revealed that he was supportive of a 25 basis point hike. Comments made by Kansas City Fed President Esther George suggested that she preferred a gradual approach to raising interest rates while Atlanta Fed President Raphael Bostic explicitly voiced opposition to a 50 basis point increase.
The Fed hike was priced in a rate increase as early as mid-February. According to a Reuters poll conducted February 7-15, all 84 respondents predicted an interest rate hike of at least 25 basis points with a minority saying 50 points. State Street Global Advisors and JPMorgan Funds economists publicly stated expectations that the Fed would begin winding down its economic assistance provided during the pandemic at the March meeting. Current pricing suggests that markets anticipate six more rate hikes this year (an increase at every meeting).
With the decision, Powell and other FOMC members successfully tamed hawks in support of a 50 basis point increase. For example, St. Louis Fed President James Bullard stated that he preferred a 100 basis point hike by July. Fed Board Governor Christopher Waller agreed with Bullard’s comments while Governor Michelle Bowman believed that “forceful action” was necessary to rein in inflation. Due to CPI data, Citi economists predicted a 50 basis point hike last month while JPMorgan Chase placed the odds of such an increase at 90 percent around the same time. For now, the hawks have been forced to roost. The Fed has signaled a cautious approach to raise rates as they seek to quell rising prices while avoiding a Fed-induced recession.
How the Sausage Gets Made
Over the last few months, Powell and other members of the FOMC highlighted multiple factors that influenced their decision to raise interest rates by 25 basis points. The decision is to help tame the elevated inflation the country has been experiencing over the last year. While the bout of inflation still remains mostly a supply-side issue due to the various bottlenecks jamming supply chains as well as the war in Ukraine, Powell has stated that as inflation has broadened to other sectors of the economy, the ability for interest rates to reduce excess demand has improved. Powell’s assessment of the mixture of demand-side versus supply-side inflation is one of the reasons the FOMC decided to raise rates by 25 basis points: there was a growing need to raise rates, but Powell does not want to replicate the Volcker Shock of the 1980s when the Fed caused a recession by raising rates too harshly.
Fed all but locked itself into a 25 basis point hike over the last month. Most other members of the FOMC including Powell and Brainard came out in favor of a 25 basis point increase. When paired with their assessments of a strong economy, the Fed invoked the principle of forward guidance. By communicating their analysis of the economy and laying out expectations for future monetary policy, the Fed effectively created a self-fulfilling prophecy for a 25 basis point interest rate increase.
Finally, the magnitude of the rate hike was cemented by the crisis that has unfolded in Ukraine. The Russian invasion of Ukraine sent gas prices skyrocketing as much of the West enacted sanctions on Russian goods and financial assets. While Europe is much more intertwined with Russia’s economy when compared to the United States, the immense uncertainty created will have negative effects on economic growth. Thus, the prospects of an interest rate hike that was too high became much more real, which meant a 25 basis point rate hike was the only option left.
Continuous Fed Funds Futures 1Y and 2Ys Out
Source: Bloomberg Professional, CME Economic Research Calculations
Even though the decision to raise interest rates by 25 basis points was made to avoid a recessionary cliff, raising interest rates will have negative effects on economic growth regardless. While the 25 basis point hike won’t induce a recession, the downward pressure will still likely manifest in the upcoming months in the monthly jobs report and GDP estimates. It won’t be a large impact, but it likely will mean fewer 600K+ jobs reports like last month’s report and slightly lower growth in the second quarter of 2022. But this is also a testament to the strong recovery created by the various Covid relief packages and the Fed’s own policies throughout the pandemic.
Ahead for the Fed and Midterms Beyond
As the Fed begins to look toward the next FOMC meeting on May 3 and 4, expect talk of another rate hike along with the first reduction in the Fed’s balance sheet, though uncertainty generated by the pandemic and conflict in Ukraine, not to mention pre-existing conditions like supply chain issues remain persistent inflationary factors a balance sheet reduction is likely another tool at the Fed’s disposal to reduce economic stimulus. And it’s probable the Fed will continue to raise interest rates probably six more times leading to a minimum federal funds rate of roughly 1.9 percent with further hikes expected throughout 2023.
The ability to discuss the likely path the Fed will take is not a coincidence. It’s a reflection of the calm and steady leadership Powell and other members of the Board — particularly Brainard — have brought to monetary policy throughout the pandemic. And we will continue to need that leadership as we deal with elevated inflation and the rest of the pandemic recovery. Thus far, the Fed has communicated its intentions effectively and should continue on this path instead of pursuing a modern Volcker Shock.
To take Powell at his word, and we generally do, his projection of a peak of price increases coming “this summer” is welcome news to all who believe it. Should it turn out to be true, this will remove an enormous economic albatross currently facing Democrats everywhere. That will be too late for most midterm primary elections to make a difference but that is not true about the midterm general election vote in the fall.