The Federal Reserve raised interest rates by 0.75 percent on June 15, 2022, the third this year and the biggest hike since 1994. The move is aimed at countering the fastest pace of inflation in more than 40 years.
Wall Street was expecting a half-point increase, but the latest consumer price report released on June 10 prompted the Fed to take more drastic measures. However, the bigger risk is that higher rates will push the economy into recession, a fear aptly expressed by the recent fall in the S&P 500 stock index, which is down more than 20% from its peak in January, Which makes it a “bear”. Market.”
What does all this mean? We asked Brian Blank, a finance scholar who studies how businesses adapt and handle economic downturns, to explain what the Fed is trying to do, whether it can be successful, and what it means for you. Is.
1. What is the Fed doing and why?
The Federal Open Market Committee, the policy-making arm of the Fed, was considering how much and how quickly to raise its benchmark interest rate in the coming months to fight inflation. The stakes are high for the US economy, consumers and businesses.
Only a week ago, the Fed was expected to raise rates by 0.5 percent at the latest meeting. But markets and Wall Street economists started expecting a bigger 0.75 point increase after inflation was unexpectedly stubborn after May’s consumer price data. Some Wall Street analysts also argued that a 1-percentage-point increase was possible.
The prospect of a sharp rise in rates due to inflation has prompted financial markets to fall by over 6% since the June 10 report. Investors worry that the Fed may slow the economy too much in its fight to contain inflation, which, if left unchecked, poses serious problems for consumers and companies. A recent poll found that inflation is the biggest problem Americans believe America is facing right now.
2. What is the Fed trying to achieve?
The Federal Reserve has a dual mandate of maximizing employment while keeping prices stable.
Often policymakers must prioritize one or the other. When the economy is weak, inflation usually subsides and the Fed can focus on keeping rates low to encourage investment and boost employment. When the economy is strong, unemployment is usually quite low, and this allows the Fed to focus on controlling inflation.
To do this, the Fed sets short-term interest rates, which in turn help influence long-term rates. For example, when the Fed raises its target short-term rate, it raises the cost of borrowing for banks, which in turn sends them to consumers and businesses in the form of higher rates on long-term loans for homes and cars. Passes high costs.
At the moment, the economy is strong, unemployment is low, and the Fed has been able to focus primarily on reducing inflation. The problem is that inflation is so high at an annualized rate of 8.6% that bringing it down may require the highest interest rates in decades, which could substantially weaken the economy.
And so the Fed is trying to execute the so-called soft landing.
3. What is a ‘soft landing’ and is it possible?
A soft landing refers to the way the Fed is attempting to slow inflation — and therefore economic growth — without causing a recession.
To stabilize prices while not hurting jobs, the Fed expects interest rates to rise very rapidly in the coming months. Including the latest rate hike, the Fed has already raised rates by 1.5 percent this year, raising its benchmark interest rate from 1.5% to 1.75%.
Historically, when the Fed has had to raise rates rapidly, it has been difficult to survive an economic downturn. Can it manage a soft landing this time? Fed Chair Jerome Powell has insisted that the central bank’s policy tools have become more effective since its last inflation fight in the 1980s, making it possible to avert a landing this time. Many economists and other observers remain uncertain. And a recent survey of economists says many anticipate a recession starting next year.
That said, the economy is still relatively strong, and I would say that the prospect of a recession starting next year is still close to the flip of a coin.
4. Is there any way to tell what the Fed might do next?
Every time the Federal Open Market Committee meets, it attempts to communicate what the financial markets plan to do in the future to help them know that they are not surprised.
One piece of guidance that the committee provides about the future is a series of points, with each point representing a particular member’s expectation for interest rates at different points. This “dot plot” previously indicated that the Fed would raise interest rates to 2% by the end of the year and closer to 3% by the end of 2023.
The latest news of inflation is forcing it to change its tune. Dot Plot now expects the Fed to have rates closer to 3.5% by December — meaning several big rate hikes are still in store this year — and around 4% in 2023 before falling again in 2024.
Long-term interest rates, such as the US Treasury yield and mortgage rates, already reflect these rapid changes. However, some investors think the Fed may have to move even faster and are forecasting closer to 4% by the end of 2022.
5. What does this mean for consumers and the economy?
Interest rates represent the cost of borrowing, so when the Fed raises the target rate, it becomes more expensive to borrow money.
At first, banks pay more to borrow money, but then they also charge individuals and businesses more interest, which is why mortgage rates rise accordingly. This is one reason mortgage payments are rising so rapidly in 2022, even as the housing market and prices begin to slow.
When interest rates are high, fewer people can buy homes and fewer businesses can invest in a new factory and hire more workers. As a result, higher interest rates can slow down the growth rate of the economy as a whole, while also curbing inflation.
And it’s not just an issue affecting Americans. Higher interest rates in the US can have a similar effect on the global economy, whether by raising their borrowing costs or increasing the value of the dollar, making American goods more expensive to buy.
But what this ultimately means for consumers and everyone else will depend on whether inflation slows as much as the Fed is predicting.
This article was updated to include the results of the announcement of FOMC interest rates.