Facing inflation that keeps soaring to new peaks, the Federal Reserve is slated to raise interest rates again Wednesday to fight it.
The Fed’s most important tool for controlling inflation is its interest rate, which the central bank raises or lowers depending on what is happening in the economy. Higher rates are a ticket to an economic slowdown, because they make a host of lending — including mortgages and business loans — more expensive.
After inflation data showed prices soared 9.1 percent in June, compared with the year before, economists and the markets are watching for any signals that the Fed might decide to hoist rates even more sharply than it previously hinted.
So far, the Fed appears likely to stick to its original plan. Here are some of the biggest economic forces guiding how Fed policymakers are thinking about what to do about the economy.
Inflation hit a pandemic-era peak last month, driven by soaring energy costs. Prices rose in practically every nook and cranny of the economy, especially food and housing.
Fed officials had been hoping that as interest rates rise and supply chains heal, inflation would decline steadily. But there is no sign yet of an easing of prices.
“The inflation reading for last month, it was high, but, critically, it was also very broad-based,” said Ellen Gaske, an economist at PGIM Fixed Income and a former senior economist at the New York Fed. “The Fed hasn’t yet seen what it needs to, to slow down.”
Right after the June consumer price index report, financial markets tanked as investors bet that the Fed would decide it needed to ramp up its response and raise interest rates more sharply, which would weigh on Wall Street.
There is precedent for a quick pivot. Days before its policy meeting in June, the Fed suddenly changed course and indicated that a larger interest rate hike than initially planned was on the table. The Fed shifted to more-aggressive action in part because of unexpectedly hot May inflation data and signs that consumer sentiment was especially gloomy. Similarly, the European Central Bank last week increased its benchmark interest rate more than expected amid high inflation.
But uncertainty about how far the Fed would go this month has been quelled by top officials, including Fed governor Christopher Waller, who said recently that although the inflation data is “a major league disappointment,” there are hazards to overreacting.
“A 75 basis-point hike is huge,” Waller said at the Rocky Mountain Economic Summit on July 14. “Don’t think because you are not going 100, you are not doing your job.”
Indeed, another force playing into the Fed’s interest-rate decision is the slowing housing market. The Fed’s previous rate increases, and expectation of more, have caused a brisk run-up in mortgage rates, pushing more buyers out of the market. Existing-home sales fell in June for a fifth straight month, according to the National Association of Realtors. And although the median sale price of a house rose to $428,006 in June, compared with last year, there are indications that prices are starting to ease in some markets.
The biggest, boldest sign that the economy is doing well is the jobs market. The country continues to gain jobs at a brisk pace, but some economists say that pace is unsustainably hot, with far more job openings than people looking for work. For the overall economy to slow meaningfully, hiring needs to wind down, too.
And the unemployment rate has held steady at 3.6 percent, near 50-year lows, for four months.
Fed Chair Jerome H. Powell often points out that two job openings are advertised for every job seeker, a sign of a mismatch in the economy.
As long as the labor market continues in overdrive, policymakers can lean toward big moves on interest rate increases.
The Fed’s goal is to cool the economy in a way that reduces demand for new hires but does not cause employers to pull back so much that unemployment surges. The glaring problem is that the Fed cannot pull that off with any precision. The Fed’s economic forecasts show the unemployment rate rising a bit as interest rates go up — meaning that some workers will lose jobs under the current plan to raise interest rates.
“We don’t seek to put people out of work, of course,” Powell said at a news conference in June. “We never think, ‘Too many people are working, and fewer people need to have jobs.’ But we also think that you really cannot have the kind of labor market we want without price stability.”
In some sectors, job cuts already are occurring. Some companies that hired rapidly during the pandemic have realized that their business models are not a fit for the post-pandemic economy, or they simply have not been able to handle the cost of inflation. Peloton has laid off thousands of workers. The delivery start-up Gopuff is laying off 10 percent of its workforce, Insider Reported. Microsoft also is making cuts.
Goldman Sachs’s chief financial officer last week said, “We have made the decision to slow hiring velocity.” Multiple mortgage lenders across the country, including Wells Fargo and Better.com, have laid off thousands of people as demand for home loans and refinancing drops off.
“There’s a difference between companies slowing the pace of hiring versus outright layoffs, and I don’t think we’re seeing that broadly across industries,” Gaske said. “There are pockets. But a slowdown in hiring would be expected at this point in the cycle.”
Still, it can be tricky to tell whether or when layoff momentum starts to build. First-time unemployment claims have been creeping up and are at their highest level since November. Still, they are nowhere near levels that would suggest a recession is imminent.
“It always starts this way, except for covid,” said Roberto Perli, a former Fed economist and the head of global policy research at Piper Sandler. “Normally, a recession starts slowly. The weakest companies, the most exposed companies, slow [their] hiring, and then they start firing.”
“The labor market is always the last shoe to drop,” Perli added.
Economic growth also influences how the Fed decides its course of action.
Around the globe, major developed nations have been reporting slower or even no economic growth, because of inflation, pandemic problems and the war in Ukraine. The United States is expected to follow that pattern.
The Bureau of Economic Analysis reports gross domestic product for April through June on Thursday, after the Federal Reserve makes its interest rate decision. But many economists already expect that the economy shrank, again.
The GDP report will fuel a whole new set of questions over whether the economy is in a recession, or approaching one. By one definition, a recession is marked by two consecutive quarters of negative growth. The economy already shrank in the first three months of the year, driven mainly by a drop-off in inventory purchases and the United States not exporting as many goods.
But a host of other signs suggest the United States isn’t in a recession. The job market is still churning. Crucially, consumers are still spending, especially on services. Businesses aren’t showing signs of widespread layoffs. Plus, the official recession call will be made by a panel of experts at the National Bureau of Economic Research (NBER), and it could be a ways away.
All of those pieces matter for the Fed, which is under tremendous pressure to avoid causing a recession by hiking rates too aggressively. The Fed’s argument is that the economy is fundamentally strong enough to withstand higher rates.
“Even the NBER wouldn’t define this as a recession,” Perli said. “You need more than two quarters of negative GDP growth. You need the labor market and so on. So, no, I don’t think [the Fed] will be stopped by potential negative print.”
After soaring for much of the pandemic, the stock market has taken a dive this year as investors grow jittery that inflation is only becoming worse and that the Fed isn’t equipped to rein it in. The markets clinched their worst six-month start to a year since 1970 and have not let up.
Market swings generally do not affect many Americans, except in their retirement accounts. But the Fed does not simply ignore financial markets, because they can reflect broader issues or unexpected turbulence brewing in the economy.
Fed officials have said that they want to see progress in the actual economy and that the Fed will not change course on the basis of the ups and downs of the stock market.
The Federal Reserve does, though, play a role in shaping financial conditions. For example, when the financial markets plummeted at the beginning of the pandemic, the Fed helped steady the financial sector by injecting trillions of dollars into the economy through a bond-buying campaign that prevented markets from seizing up. More recently, though, the financial system has not needed that kind of support. Not only has the Fed stopped its asset-purchase program, but it also has begun shrinking its balance sheet to further tighten conditions on Wall Street.
Higher Fed interest rates and tighter financial conditions also raise borrowing costs for households and businesses and are key to slowing growth and consumer demand.
Plus, the Fed does prioritize clear communication to the markets on what it plans to do next. Signals that the Fed still leans toward a three-quarter-point increase are intended to avoid surprising the markets.
“I think they’re not really thrilled with the amount of volatility, but they’re happy that conditions are tighter on average,” said Tim Duy, a Fed expert at the University of Oregon and the chief economist at SGH Macro Advisors. “That was the one of the goals here.”
Manufacturing and productivity
Another force that the Federal Reserve monitors is manufacturing.
Manufacturing activity is one a linchpin of the economy, because it creates jobs and is linked to all sorts of other economic activity, reflecting overall demand in the overall economy. For example, a factory that builds a heating and cooling unit also creates business by subcontracting with companies that make parts for each machine, and those businesses work with other companies, and so on.
One benchmark to which policymakers pay attention is a survey of manufacturing activity from the Institute for Supply Management. The June survey showed the volume of new orders contracted for the first time in two years, suggesting a slowdown.
Survey data released Thursday from the Philadelphia Fed also showed that manufacturing activity in the region declined overall in July.
These downward trends could be a way to gauge whether consumers and businesses are starting to pull back, reflecting higher interest rates are working to dampen economic activity. That is not necessarily a bad sign.
Even as manufacturing may be slowing, it is possible that the economy could get a boost from investments that businesses made earlier in the pandemic on tech equipment and software, especially as more people were working remotely. Companies also have been able to beef up their inventories in the past few months.
“What’s critical for a positive outlook is that companies continue to invest,” said Gaske, of PGIM Fixed Income. “It’s going to be the workaround for a tight labor market. It’s going to be a key factor to dampen inflation pressures over time.”
However, if the manufacturing survey dips sharply for a longer period, that also could signal that the economy is teetering toward a recession.