Just last month, the Federal Reserve was set on keeping its key interest rate near zero to boost the economy and help more Americans return to work after the COVID-19-induced recession.
Now, the Fed seems nearly as determined to raise the short-term rate to fight inflation.
In an effort to rein in price increases that hit a 39-year high last month, the Fed on Wednesday agreed to clear the way for earlier and faster interest rate hikes in 2022 by accelerating the phaseout of its bond-buying stimulus.
The turnabout, which Fed Chair Jerome Powell signaled during congressional testimony late last month, came after consumer prices spiraled higher, reaching 6.8% annually in November, and the unemployment rate tumbled to 4.2% that same month. The latter development highlights widespread worker shortages that could intensify, driving up wages.
But the Fed faces a delicate balance as it aims to curtail inflation without disrupting the recovery. COVID spikes driven by the omicron variant are threatening to slow an economy that’s already set to cool next year. The central bank lowers rates to spur more borrowing and economic activity and raises them to ward off inflation surges.
The Fed’s policymaking committee left its benchmark rate near zero but now projects three rate hikes next year, up from one in its September forecast, according to officials’ median estimate. They foresee three more increases in 2023 and two in 2024. That would push the rate to 2.1% by the end of 2024.
To set the stage for earlier rate increases, the Fed said it would pare back its Treasury and mortgage bond purchases by a total $30 billion a month, up from the $15 billion it announced in November. The faster wind-down puts the central bank on track to conclude the bond purchases – which are aimed at pushing down long-term rates, such as for mortgages — by March instead of June.
That opens the door to rate increases as soon as March because Powell has said officials aren’t likely to withdraw support from the economy by lifting rates at the same time they’re adding support by purchasing bonds.
In a statement after a two-day meeting, the Fed also removed its description of inflation as “transitory.” Instead, it simply said, “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”
For months, Powell and the Fed have pinned sharply rising prices on COVID-related supply and demand imbalances that would soon pass. But at the congressional hearing, Powell noted the supply-chain snarls at the center of the price surges likely would last well into next year, adding “I think it’s probably a good time to retire that word (transitory).”
The Fed also removed an assertion that inflation has “run persistently below” the Fed’s 2% goal. Instead, it said, “ with inflation having exceeded 2% for some time, the (Fed) expects it will be appropriate to” keep rates near zero until the economy has reached full employment.
The statement added, “Risks to the economic outlook remain, including from new variants of the virus.”
Fed officials now predict the economy will grow a still-vibrant 5.5% this year, down from their 5.9% estimate in September. They forecast 4% growth in 2022, up from their prior 3.8% estimate. They predict the 4.2% unemployment rate will end this year at 4.3% and 2022 at 3.5%, below their previous 3.8% projection.
The Fed’s preferred inflation measure – called the personal consumption expenditure price index — is expected to stay higher for longer, closing out this year at 5.3% and 2022 at 2.6%, up from prior estimates of 4.2% and 2.2%, respectively. A core measure that strips out volatile food and energy items is forecast to end this year at 4.4% and 2022 at 2.7%, up from previous estimates of 3.7% and 2.3%.
But the Fed faces a quandary. Last year, with millions of Americans out of work during the depths of the pandemic, it vowed to keep its key rate near zero until the economy reaches full employment and inflation rises above its 2% target “for some time.” Fed officials now say the inflation goal has been met and the economy is drawing close to satisfying the employment mandate, with the jobless rate not far above the half-century low of 3.5% reached before the health crisis.
But with the supply bottlenecks starting to ease, most economists expect inflation to soften but remain elevated in coming months. Meanwhile, the historically low unemployment rate doesn’t account for the several million Americans who aren’t even looking for jobs because they can’t find or afford child care, they’re fearful of contracting COVID or they’re still living off government stimulus checks or enhanced unemployment benefits.
To truly achieve full employment, the Fed would like to draw those people on the sidelines back into the job market, Barclays says in a research note.
But that could be tougher if the Fed is raising rates to tame inflation that may already be easing by next spring but that officials feel they still need to address to avoid a longstanding episode that derails the recovery.
“The Fed is in a difficult position,” Barclays wrote in a note to clients. “Underpinning a durable labor market expansion will be more difficult (though not impossible) with the Fed lifting rates to ward off risks to longer-run inflation outcomes.”
Also, COVID’s omicron variant could further slow an economy that’s already expected to pull back next year because of a sharp drop in federal government stimulus.
“It is less clear if the (Fed) would hike amidst sharply falling inflation and growth, even if the year-on-year rate of inflation remains high,” Goldman Sachs said in a research note.
In other words, the Fed could hold off, or pause, rate hikes depending on actual growth and inflation but striking that balance could be challenging.