The Federal Reserve is not letting up on its inflation fight, hiking interest rates by a quarter of a percentage point on Wednesday, while signaling that it will continue to increase borrowing costs even at the risk of lost jobs.
Fed Chair Jerome H. Powell said the scaled-down hike should not be misinterpreted for a scaled-down inflation fight. Inflation has eased for the past six months, but the Fed aims to fully root out price increases throughout the economy and keep them from becoming permanent.
“We have to complete the job,” Powell said Wednesday. “That’s what we’re here for.”
The bleak reality, though, is that finishing that job requires pain. The country has avoided a recession so far, but no one knows whether the job market or consumer spending — critical engines of the U.S. economy — could worsen. So far, layoffs have largely been limited to sectors such as tech, finance, housing and media. And although consumer spending is pulling back, particularly on purchases of goods, it is still strong enough to fuel expectations for economic growth in the coming months. That leaves the Fed with the fraught job of understanding whether the economy is slowing too much, not enough or somewhere in the middle.
There is no guarantee the labor market will keep adding jobs. One big problem is whether the remaining causes of inflation are no longer from supply chain problems or energy price volatility due to the war in Ukraine, but rather from a tight labor market. For more than a year, there has been pressure on employers to lift wages to keep and attract workers, especially because there are far more job openings than people seeking work, and because many older workers retired, while other people sat on the sidelines.
“It is a good thing that the disinflation that we have seen so far has not come at the expense of a weaker labor market,” Powell said. “But I would also say that that disinflationary process that you now see underway is really at an early stage.” Powell did not say whether his expectations for the unemployment rate have changed, but he noted that policymakers will release new economic projections at their next meeting in March.
Officials are now entering a new phase of their inflation fight, opting for quarter-point hikes to slowly get borrowing costs up to a level where they will be high enough to cool consumer demand and slow the economy. Rate hikes increase the cost of borrowing on a range of lending, including business, housing and car loans, slowing down parts of the economy as consumer demand falls. Quarter-point hikes are the more typical way that the Federal Reserve has moved in the past.
Once Fed officials feel as if borrowing costs are high enough to bring inflation down, they will hit pause on rate hikes and let their policies take hold.
Despite the risks of a cooling economy caused by higher rates, policymakers are “clearly encouraged” by data from the past few weeks that suggest that the economy is slowing, but not cratering, said Tim Duy, a Fed expert at the University of Oregon and chief economist at SGH Macro Advisors. On Wednesday, job openings surged to a high not seen since last summer, reflecting the ongoing demand for workers. At the same time, pay and benefits for America’s workers grew at a slower pace in the final months of 2022, according to the Bureau of Labor Statistics, suggesting an easing of pressure on employers that could help inflation.
“It confirmed our suspicion that they are becoming much more optimistic about the ‘soft landing’ scenario,” Duy said. “They’ll have a lot more information by the time of the March meeting. But the recent inflation data has made them more optimistic.”
What remains to be seen is whether that approach will work and how long it will take. Plus, there’s ongoing fear that the Fed is making decisions now that will smother the economy too much later this year.
“Inflation is now slowing in a manner that will provide the Fed with several degrees of freedom to respond to what looks like a slowing of the U.S. economy,” said Joe Brusuelas, chief economist at RSM.
After falling for much of the day, financial markets flashed green after Powell’s remarks. Shortly before the close, the Dow Jones industrial average was up 232 points, or 0.68 percent. The S&P 500 was up 1.72 percent, and the Nasdaq was up 2.7 percent.
The expected hike brings the Fed’s policy rate to between 4.5 and 4.75 percent. Officials have signaled that they plan to move rates past 5 percent this year.
Some Fed officials — including Vice Chair Lael Brainard, who is a leading contender to leave the central bank to become President Biden’s top economic adviser — have warned about the consequences that could hit the labor market and broader economy if the central bank goes too far. Compounding that problem is that interest rate policy works with a lag, and the Fed might not know whether it has slowed the economy too much until it is already too late to reverse course.
Still, there are encouraging signs that the Fed’s approach is working. Inflation has eased for the past six months, down from a June peak of 9.1 percent, compared with the year before, to the current level of 6.5 percent. And on Tuesday, the Bureau of Labor Statistics released a closely watched report on the cost of labor, which showed that pay and benefits rose less than expected at the end of 2022. That offered a sign that the labor market is cooling while still holding strong. Consumer spending is also pulling back, falling 0.2 percent in December and 0.1 percent in November, according to the Commerce Department.
The global economy has avoided a brutal downturn — at least so far. The U.S. economy grew by 2.1 percent last year, clinching six months of growth even in the face of high inflation and steep rate hikes. European manufacturing appears to be expanding. And in a newly reopened China, consumers are spending again. On Monday, the chief economist of the International Monetary Fund told reporters that “we are not seeing a global recession right now” and that the outlook ahead is “less gloomy” than its forecast from just a few months ago.
But officials have made clear that they’re far from confident that pandemic-era price increases won’t become a permanent feature of life in America. Although the past year was by no means easy, policymakers now face an unusually difficult phase of the inflation fight. Much of the reason inflation has improved over the past few months is because, in some sectors, price increases turned out to be temporary. Gas and energy prices spiked after Russia’s invasion of Ukraine but have since cooled down. Improving supply chains have helped ease prices for things such as used cars and trucks, which depend on production of new cars and auto parts to stay in stock.
But there’s reason to worry that, to get inflation down to the Fed’s 2 percent goal, the economy will have to take on the sources of inflation that could prove the stickiest. Powell and many of his colleagues have directed their attention to a narrow measure that focuses on services outside of the food, energy and housing markets. That’s where inflation can be especially hard to peel back and either be driven by — or put more pressure on — wages. That could happen in industries such as health care, education and hospitality.
Asked on Wednesday whether the hard part of the inflation fight is yet to come, Powell said: “I don’t think we know, honestly.”