Fed Raises Key Rate by 75 Basis Points, the Largest Increase Since 1994
The U.S. Federal Open Market Committee (FOMC) raised its key policy rate by three quarters of a percentage on June 15th to battle higher inflation. In its third interest rate hike since the start of the COVID pandemic, the Federal Reserve (the Fed) increased the Federal Funds Target rate to an upper bound of 1.75%. This is the first 75 basis points (bps) move the Fed has initiated in nearly three decades; showcasing not only the rarity of the change, but also the unique set of challenges currently facing the Central Bank.
In addition to raising rates, the FOMC also guided that the reference interest rate could end the year at 3.4% in its “dot plot” projections. Given then current 1.75% reference rate, the existing guidance would imply roughly 175 basis points in further tightening. That could mean that the FOMC is leaning towards front-loading its rate increases. It could increase rates by a further 75 basis points in its next meeting in July, followed by 50 basis points in September and end the year with 25 basis points increases in November and December.
In a sign of how quickly the inflation picture has shifted in the U.S., the current year end target of 3.4% is up almost 2% from the 1.9% projection from the central bank in March. Furthermore, the FOMC also amended its statement from its May meetings in two crucial ways. First, it added a line saying it’s “strongly committed to returning inflation to its 2% objective” and, second, removed prior language that said the FOMC “expects inflation to return to its 2% objective and the labor market to remain strong.” Similar shifts in the language of the statement in the past have been a precursor to more rate hikes.
Further to providing guidance for interest rates in the short-term future, the FOMC also released its near-term economic growth forecasts. The committee now expects the U.S. economy to grow at 1.7% rate in 2022 and 2023, down from prior estimates of 2.8% and 2.2% for 2022 and 2023, respectively. It also marginally lowered its growth expectations for 2024, expecting the economy to expand by 1.9% versus a prior forecast of 2% growth. The Atlanta Fed also released an update on its statistical projection for second quarter 2022 growth, which was adjusted down to 0%. Despite this downward estimate, the Fed highlighted that the U.S. economy was at strong spot and well-positioned to absorb higher interest rates.
The downward projection from the Atlanta Fed followed the U.S. retail sales report published by the Census Bureau, which showed retail sales were down in the month of May, led by a huge slowdown in auto sales and other big-ticket items. Auto prices have climbed precipitously this year, due to semiconductor shortages and rising wage expenses for manufacturers such as GM and Ford. The report suggests that U.S. consumers are pulling back on their demand for goods and finished products as spending on necessities such as gasoline and food surges.
Any demand destruction on discretionary spending would be seen as a relative success by a Federal Reserve that is trying to tamp down prices by increasing financing and liquidity costs. The FOMC also released its forecasts for inflation numbers. The Fed utilizes a different metric to measure inflation than the more widely used Consumer Price Index, called the Personal Consumption Expenditure Index (PCE Index.) The FOMC expects the PCE to average 5.2% in 2022 but also predicted a sharp drop to 2.6% in 2023 and 2.2% in 2024. The forecast for next year is indicative that the Fed is determined to get inflation down to its 2% target relatively quickly.
The FOMC’s supersized hike, coming even amongst rising fears of a recession, reflects the Fed’s worry over the recent increase in inflation expectations. Chair Jerome Powell is determined not to repeat the mistakes of the 1970s, when the economy overheated under the leadership of then Chair Arthur Burns, who led the central bank during the wage-price spiral of the decade. With signals of more tightening to come, the FOMC is trying to catch up and rectify its error from 2021 when it believed that inflation would remain contained and transient. Some market participants are concerned, however, that the Fed is already too late in tightening policy, and that a core component of inflation is outside of the Fed’s control anyway.
The spring back of demand as the pandemic dissipates, combined with supply shortages, has caused prices to increase faster than initially anticipated by the Fed. Adding to the misery, supply chain bottlenecks due to operational and shipping issues worldwide have exasperated these troubles. Lastly, energy and food prices have surged globally after Russia’s invasion of Ukraine, and the UN is predicting food shortages for many parts of the world. The Fed, historically, has had little success in influencing inflation from supply-side shocks.
Shelter, and specifically the housing market, could be another spot of trouble for the Fed to deal with in the coming few months. As the Fed raises rates, mortgage rates rise in unison, stretching buyers’ capacity to finance home purchases. When there are fewer buyers, pricing in the housing market tends to correct swiftly. The national average 30-year mortgage rate in the U.S. has now climbed to 6.3% from around 3% a year ago. A move of this magnitude has generally precipitated a crash in home prices in the past. The decline in housing prices could also lead to a weakening of the “wealth effect” and cause the economy to contract further.
Unsurprisingly, segments of the market are flashing warning signs of stagflation, the phenomenon where high inflation and a recessionary growth environment occur simultaneously. The FOMC’s task in the near-term, therefore, would be to balance raising rates and removing liquidity from the system fast enough to reduce demand, but not rapidly enough to squash economic momentum. Given the difficult balancing task, there are real concerns around the Fed’s ability to manage the economy to achieve a “soft-landing”, where a deep and swift recession is avoided.
Chair Powell also indicated in his press-briefing following the rate hike that he expects the unemployment rate to increase to 3.7% to end 2022, and 3.9% to end 2023, in line with the FOMC’s median expectations. The current unemployment figure of 3.6%, very low by historical standards, has created an extremely tight labor market and forced employers to raise wages that in turn has had a knock-on effect on inflation. The Chairman also said that a 4.1% unemployment rate would be “considered a successful outcome” and that the Fed is not trying to induce a recession to pull back inflation. He also stressed that the rate-setting committee will remain flexible and adjust policy to incoming data.
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