Federal Reserve escalates inflation fight with biggest rate hike since 1994

The central bank raised its benchmark rate by three-quarters of a percentage point and said increases would continue until inflation was under control.

As the Federal Reserve announced a rate change, traders worked on the floor at the New York Stock Exchange Wednesday.Seth Wenig/Associated Press

The Federal Reserve ratcheted up its fight against inflation on Wednesday with its steepest interest rate increase since 1994, calling a game-day audible after being unsettled by an unexpected spike in already-high consumer prices last month.

Concluding a regularly scheduled two-day meeting, central bank officials said in a statement that they voted to boost the benchmark federal funds rate by three-quarters of a percentage point. The increase, which lifts the fed funds rate to a range of 1.5 to 1.75 percent, will push up the cost of mortgages, credit card debt, and car loans, as well as making it more expensive for businesses to borrow.

Fed Chairman Jerome Powell, who has been criticized for moving too slowly when inflation accelerated last year, vowed to continue raising rates until prices were under control. New central bank forecasts released Wednesday indicated that officials expect to jack up rates through next year at the fastest pace in decades.

Interest rates are the Fed’s primary tool to control inflation, which is running at more than three times its long-term target of 2 percent. The Fed had also pumped money into the economy during the COVID recession by buying bonds. It is now tightening credit and draining money from the financial system to curtail consumer spending and business investment. That will likely relieve pressure on prices and wages.

The danger is that rates move too high too quickly, and households and corporate executives retrench too deeply, leading to a recession and a big rise in unemployment. Success requires a level of precision that isn’t easy to achieve with a blunt instrument like interest rates.

“There are risks of not doing enough” and allowing higher prices to become ingrained in the economy, said Claudia Sahm, a consultant and former Fed and White House economist. “And there are risks of doing too much. The consequence is a recession.”

The Fed previously hiked rates twice this year, by a half-point in May and a quarter-point in March. Those modest increases — from a base of near zero — combined with a phase-out of its bond-buying program and clear guidance that rates would continue to increase are beginning to have the desired effect.

The housing market is flashing early signs of a modest cooling-off as mortgage rates top 5 percent, while some real estate firms are cutting workers. The Commerce Department said Wednesday that retail sales dipped a seasonally adjusted 0.3 percent in May from the previous month, the first such decline this year.

“The American economy is very strong and well prepared to withstand tighter monetary policy,” Powell said during a news conference. But the labor market is “extremely tight and inflation is much too high.”

Powell acknowledged that more needs to be done and that achieving a “soft landing” — returning to the Fed’s preferred inflation rate without inducing a recession — has been made much more difficult by variables outside of its control. Those factors include the war in Ukraine, which has accelerated already-troubling increases in energy and food prices, and pandemic-related contortions in the supply and demand of some goods and services.

“This is an extraordinarily uncertain environment,” he said.

So uncertain, that up through earlier this month Fed officials had signaled they would make more modest half-point increases on Wednesday and at their next meeting, in July.

But on Friday, the Labor Department said that consumer prices in May rose 8.6 percent from a year earlier, the biggest year-over-year increase since 1981. Moreover, two widely followed monthly surveys — one by the University of Michigan released on Friday, the other published by the Federal Reserve Bank of New York on Monday — showed consumers anticipated inflation remaining well above 2 percent for the next one- and five-year periods.

Elevated inflation expectations are important because they can affect prices. As Tyler Powell and David Wessel explained in a Brookings Institution blog post, “If everyone expects prices to rise, say, 3 percent over the next year, businesses will want to raise prices by (at least) 3 percent, and workers and their unions will want similar-sized raises.”

Powell said the inflation data and survey results were enough to persuade Fed officials to make a rare last-minute call on the bigger rate hike.

Members of the rate-setting Federal Open Market Committee will likely increase rates by a half point or three-quarters of a point at their next meeting, Powell said, with the decision hinging largely on whether there is any evidence inflation has plateaued.

The consensus among Fed officials in their new forecasts is that additional increases will bring its main interest rate to 3.4 percent this year, with economic growth downshifting significantly. FOMC members see this as a so-called neutral level that keeps inflation at preferred levels while supporting maximum employment.

The Fed’s preferred measure of inflation is expected to be 5.2 percent for this year, according to the median of the officials’ forecasts. The projection for 2023 is 2.6 percent.

The jobless rate was pegged to reach 4.1 percent in 2024. Unemployment stood at 3.6 percent in May, suggesting the Fed believes it can tame inflation without putting too many people out of work.

The forecasts drew some skeptical reactions from economists who think the Fed is too optimistic.

Fed officials are “clearly taking inflation ever more seriously, which is surely a good thing. However, they are still a substantial distance from realism in their economic forecasting,” said Lawrence Summers, the Harvard economist and former Treasury secretary. “Just as there were major upward revisions in Fed forecasts of unemployment, inflation, and interest rates, I expect more revisions are to come.”

Financial markets, which had been in a tailspin over the past week, applauded the Fed’s aggressive rate hike, with stock prices taking off after Powell began speaking at his news conference. The Standard & Poor’s 500 index ended the day up 1 percent, while the tech-heavy Nasdaq gained 2.5 percent.

The yield on the 10-year US Treasury note dropped to 3.28 percent from 3.47 percent on Tuesday. The 10-year yield was under 2 percent as recently as mid-March.

Still, the Fed had to carefully weigh the impact of departing from its guidance to investors: If officials had stuck with a half-point increase, there was the risk they’d been seen as too timid on inflation. The heftier hike, on the other hand, may be taken as a sign that the situation has grown more dire. Also, breaking with their widely telegraphed half-point increase may call into doubt the reliability of future Fed guidance on interest rates.

“It is disquieting that the Fed appears to be ad-libbing monetary policy,” said Mark Zandi, chief economist at Moody’s Analytics. “This suggests policy makers don’t have a clear strategy for quelling inflation and keeping the economy out of recession. Thus, the risks they fail, and a recession ensues, are uncomfortably high and on the rise.”