The Federal Reserve is raising interest rates for the third time this year on June 15, 2022 to counter inflation, which has been running at its fastest pace in over 40 years. The big question is how much it will hike rates. Ahead of the latest CPI report on June 10, most market watchers and economists were expecting a 0.5 percentage point rise. But now more and more are expecting a 0.75-point rise — the biggest in almost 30 years. The risk is that higher interest rates will push the economy into recession, a fear aptly illustrated by the recent plunge in the S&P 500 stock index, which has fallen over 20% from its peak in January, turning it into a ” bear market”.
What does it all mean? We asked Brian Blank, a finance scientist who studies how companies adapt and cope with economic downturns, to explain what the Fed is trying to do, if it can succeed, and what that means for you.
The Federal Open Market Committee, the Fed’s monetary policy arm, is currently considering how much to raise interest rates. The stakes for the US economy, consumers and businesses are high.
In recent weeks, Fed Chair Jerome Powell has signaled that the Federal Reserve is likely to raise interest rates by 0.5 percentage point to a range of 1.25% to 1.5%. But markets and Wall Street economists are now expecting a larger 0.75-point rise as May CPI data suggest inflation has been more resilient than expected. Some Wall Street analysts believe a 1 percentage point increase is possible.
Since the latest CPI data was released on June 10th, the prospect of faster rate hikes has seen financial markets plunge by 5%. Investors worry that the Fed could slow down the economy too much in its fight against inflation, which, if left unchecked, could also pose serious problems for consumers and businesses. A recent poll found that inflation is the biggest problem facing the US right now.
The Federal Reserve has a dual mandate to maximize employment while keeping prices stable.
Policy makers often have to prioritize one or the other. When the economy is weak, inflation is usually subdued and the Fed can focus on keeping interest rates low to boost investment and boost employment. When the economy is strong, unemployment is usually fairly low, and that allows the Fed to focus on controlling inflation.
To do this, the Fed sets short-term interest rates, which in turn help it influence long-term interest rates. For example, when the Fed raises its short-term target interest rate, it raises the cost of borrowing for banks, which in turn pass those higher costs on to consumers and businesses in the form of higher interest rates on long-term home and auto loans.
At the moment the economy is pretty strong, which is unemployment
low and the Fed can focus primarily on reducing inflation. The problem is that inflation, at an annualized rate of 8.6%, is so high that a fall could require the highest interest rates in decades, which could significantly weaken the economy.
And so the Fed is trying to do what is called a soft landing.
A soft landing refers to the Fed’s attempt to curb inflation — and thus economic growth — without triggering a recession.
In a bid to stabilize prices while not hurting employment, the Fed is expected to raise interest rates rapidly in the coming months – and it currently forecasts at least 1 percentage point higher rates through 2023. It has already raised its key interest rate twice this year by a total of 0.75 percentage points.
In the past, it was difficult to avoid economic downturns when the Fed had to raise interest rates quickly. Will it make a soft landing this time? Powell has insisted his policy tools have become more effective since his last inflationary battle in the 1980s, making it possible to survive the landing this time. Many economists and other observers remain uncertain. And a recent poll of economists finds many expecting a recession to start next year.
However, the economy is still relatively strong and I would say the likelihood of a recession starting next year is probably still close to a coin toss.
Every time the Federal Open Market Committee meets, it tries to share what it plans to do in the future so the financial markets know what to expect so they don’t get caught off guard.
One guidance for the future offered by the Committee is a series of bullet points, with each bullet point representing a particular member’s interest rate expectation at different points in time. This “dot plot” has previously indicated that the Fed will hike rates to 2% this year and 3% soon.
Given the inflation news since the last session, investors are now forecasting an even faster pace of rate hikes and expecting the target rate to be above 3% by 2023 to reflect these rapid changes.
As such, investors and economists will be watching as the Fed’s dot chart changes after it announces its interest rate decision on June 15, which will determine how quickly committee members expect to raise interest rates in the coming months.
Interest rates represent the cost of borrowing, so if the Fed raises the target interest rate, borrowing becomes more expensive.
First, banks pay more to borrow money, but then they charge more interest to individuals and businesses, and mortgage rates go up accordingly. This is one of the reasons why mortgage payments have risen so quickly in 2022 even as property markets and prices are beginning to soften.
When interest rates are higher, fewer people can afford to own their own homes and fewer companies can afford to invest in a new factory and hire more workers. As a result, higher interest rates can slow overall economic growth while curbing inflation.
And this is not a problem that only affects Americans. Higher interest rates in the US can have similar effects on the global economy, whether by raising the cost of borrowing or by making the dollar appreciate, making US goods more expensive to buy.
But what it ultimately means for consumers and everyone else will depend on whether the pace of inflation slows as much and as quickly as the Fed forecast.
By D. Brian Blank, Assistant Professor of Finance, Mississippi State University
This article was republished by The Conversation under a Creative Commons license. Read the original article.