When the Federal Reserve first raised interest rates by a whopping three-quarters of a percentage point in June, Chair Jerome H. Powell said the hike was an “unusually large one.”
The Fed is still dashing to catch up to inflation. The pandemic has chucked nearly every playbook, and it continues to cloud policymakers’ understanding of what’s happening in real time. After misjudging inflation for much of last year, the Fed is now scrambling to hoist rates from historic lows, and get its benchmark rate high enough to where it slows growth and consumer demand. So far, the supersized interest hikes haven’t been enough to show the progress central bankers want.
But that ramped-up response also means a ramped-up risk that the economy could soon be dragged into a recession. Rate hikes of any size operate with a lag, and already the Fed’s moves are driving up mortgage rates and causing economists to downgrade their forecasts for growth. But the full weight of the Fed’s massive hikes still won’t be felt until later this year or 2023.
Stock markets were up slightly Monday.
Krishna Guha, vice chairman of Evercore ISI, said the Fed has “put itself in a bit of a box” by making three-quarter point hikes a new norm. The central bank has offered little guidance on when or how it will decide to slow down — or how it will react if the economy cools too much too fast.
“You’re taking very big steps on rates, moving rates higher very rapidly, before you have time to learn from the data, and learn whether the level of rates is about right, a bit too much or a bit too little,” Guha said. “In effect, your decisions are outrunning your ability to learn from the data.”
Fed officials are starting to acknowledge the hazards of moving at such a torrid pace. In a speech this month, Fed Vice Chair Lael Brainard said that “at some point in the tightening cycle, the risks will become more two-sided,” noting uncertainty around the time it takes for tighter monetary policy to filter through the global economy. Richmond Fed President Tom Barkin told the Financial Times this month that he prefers “moving more quickly, rather than more slowly” on raising rates, “as long as you don’t inadvertently break something along the way.”
For now, though, bank officials show no signs of backing down. They’re reiterating the message that they will stomp out inflation, even if it brings pain for families and businesses or harms the job market.
For weeks, the markets have priced in a third three-quarter-point hike at the Fed’s September meeting, set to take place Tuesday and Wednesday. That seems all but guaranteed now that August inflation data came in unexpectedly hot, especially for core items like housing and food.
Wall Street recoiled over the inflation report last Tuesday, with the Dow Jones industrial average nosediving more than 1,200 points on fears that the Fed would have to keep up with its supersized hikes. The markets slumped through the rest of last week, too. The report also spurred speculation among some economists and market analysts that the Fed should hike by a full percentage point this week.
Diane Swonk, chief economist at KPMG, said a full-point hike should be on the table, since the Fed’s credibility is on the line. But she acknowledged that wouldn’t come without consequences.
“Even though here I am arguing for an even bigger increase, the real issue is rapid increases themselves are destabilizing,” Swonk said.
Historically, the Fed has moved slowly and deliberately, inching rates up or down by a quarter of a percentage point. Exceptions include major emergencies such as the Sept. 11 attacks or the financial crisis that started the Great Recession. And indeed, at the start of the coronavirus pandemic, the Fed slashed rates to near zero as part of its sweeping rescue.
Last year, the Fed held off on raising rates at all, with officials saying the inflation that was bubbling up would be a temporary feature of the covid recovery. That was wrong, and the Fed ultimately hustled to start raising rates this March. It is now on track to push rates past the “neutral” zone of roughly 2.5 percent, where rates don’t slow or juice the economy, and into “restrictive territory” that dampens consumer demand and gets inflation down. This week’s expected hike would get rates between 3 percent and 3.25 percent, and rates are expected to climb to at least 4 percent by the end of the year.
“There is an element of — panic is one word, a realization of how far behind you are is another,” said Julia Coronado, president of MacroPolicy Perspectives and a former Fed economist. “But it is a dangerous moment because everybody globally, all central bankers, seem to be jumping on the same bandwagon.”
Indeed, the Fed’s supersized hikes could pack that much more of a punch as the world’s major economies ramp up their inflation fight at the same time. On Thursday, the World Bank said that the global economy may be edging toward recession as central banks from Australia to Europe tighten policy. Already, economic growth is slowing across the United States, Britain, Europe and China. And while the Fed’s policies are strengthening the dollar, poorer nations could quickly suffer the consequences, as higher rates push up the cost of financing debt or importing goods for countries that borrow in dollars.
The grim reality, however, is that pain in the United States and abroad may be necessary to rid the economy of its biggest problem. Kaleb Nygaard, an expert on Fed history and host of the Reserve Podcast, compared the economy to a forest, and the Fed to park rangers who sometimes have to set small fires to clear out unwanted underbrush.
“This time around, rangers are trying to do more controlled fires, trying a lot harder not to burn down so many trees,” Nygaard said. “But they’re nervous that the interest rate hikes they’ve done so far haven’t slowed inflation enough. These large interest rate hikes are like the rangers loosening the reins on the fire and letting them burn just a little bit hotter and a little bit wider.”
“The underbrush is proving tougher to get rid of than they had hoped,” he added, “which means they may have to sacrifice more trees than originally hoped to clear the forest.”