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Fed hikes rates by half a percentage point in fight against inflation

The sharpest rate increase since 2000 comes as the Fed tries to slow the economy without causing a recession

Federal Reserve Chair Jerome H. Powell on May 4 said there is a “good chance” the United States tamp down inflation via rate hikes without causing a recession. (Video: The Washington Post)

The Federal Reserve raised interest rates Wednesday by half a percentage point and scaled back other pandemic-era economic supports, strengthening its efforts to fight the highest inflation in 40 years and vowing to keep up the pressure as Americans continue to struggle.

“Inflation is much too high,” Fed Chair Jerome H. Powell said at a Wednesday news conference. “We understand the hardship it is causing, and we are moving expeditiously to bring it back down. We have both the tools we need and the resolve that it will take to restore price stability on behalf of American families and businesses.”

The rate increase is the sharpest since 2000 and the second of seven hikes forecast for this year. Powell added that additional interest rate hikes as high as 0.5 percentage points are “on the table” in the coming months but said policymakers had not seriously discussed even sharper hikes. Major financial markets edged higher during his remarks, as investors signaled relief that the Fed wouldn’t move more aggressively.

Faced with soaring prices and a hot job market with record numbers of job openings, the Fed is betting that a steady series of hikes will slash inflation, cool the economy and get the coronavirus recovery on more sustainable footing, at a time when much uncertainty looms in the global economy. Russia’s invasion of Ukraine has driven up energy prices, and covid-19 shutdowns in China have triggered a new wave of supply chain snarls, both threatening to make the Fed’s job much harder.

Powell said he understood that the stakes are high for Americans, many of whom have never weathered inflation and are already straining to cover costs of groceries, gas, rent and other necessities.

“It’s our job to make sure that inflation of that unpleasant high nature doesn’t get entrenched in the economy,” Powell said. “The process of getting there involves higher rates — higher mortgage rates and higher borrowing rates, things like that. It’s not going to be pleasant either, but in the end everyone is better off — everyone. Particularly people on fixed incomes and at the lower part of the income distribution are better off with stable prices.”

Mortgage rates are rising, but the hot housing market is slow to cool

Indeed, interest rate hike will make an array of loans costlier for households and businesses, especially mortgage rates, which have already been inching up. Higher lending costs tend to cool the economy by weighing on business and consumer spending, and eventually lead to lower prices overall, especially for necessities such as housing, gas and groceries.

Policymakers have spent weeks setting expectations for Wednesday’s rate hike. But at a time when inflation dominates the way families view the economy, Fed officials must explain how its policies actually shape peoples’ lives. Powell began his remarks Wednesday taking an unusual step of saying he would “like to take the opportunity to speak directly to the American people,” before making his remarks that policymakers know that inflation is too high and understand how much that hurts families.

“That was interesting, to say: ‘We’re not just doing this for financial markets. We’re doing this because the public needs it. We really think the public is being hit by inflation, and we’re on it,’” said Tim Duy, a Fed expert at the University of Oregon and chief economist at SGH Macro Advisors.

An interest rate hike will affect anyone with a home mortgage, car loan, savings account or money in the stock market. (Video: Daron Taylor/The Washington Post)

The economy could stumble if the Fed’s plans go awry or if inflation becomes even more entrenched. Policymakers must move slowly with hikes and not too forcefully to raise interest rates too quickly, which could prompt businesses to lay people off or send the country into recession.

“Any one 50-basis-point hike has pretty small implications for the economy,” said Stephanie Aaronson, an economist at the Brookings Institution who spent nearly two decades at the Fed. “We’ve already seen some tightening — in the form of higher rates, say, for mortgages — and we can expect to see even further tightening as the Fed continues to raise rates. But it shouldn’t be dramatic. It should gradually slow the economy over the next year or so.”

Already, there are signs that some parts of the recovery may be stalling. The U.S. economy unexpectedly shrank by 1.4 percent in the first three months of the year, due largely to increasing trade deficits and falling inventory purchases, fueling new concerns about how things might play out later this year. That uncertainty, combined with disappointing earnings reports, sent markets tumbling late last week.

Markets tank over new questions about where the economy is heading

“The Fed now finds itself in a peculiar situation where it’s forced to implement aggressive policy tightening at a time when economic indicators are beginning to soften,” Peter Essele, head of portfolio management at the Commonwealth Financial Network in Waltham, Mass., said in an email. “The performance of recent equity markets would suggest that investors aren’t too convinced the Fed can engineer a parachute landing this time around with the economy.”

In March, the Fed raised rates for the first time since slashing them to zero in the spring of 2020, opting for a more modest rate hike of a quarter percentage point. That month, inflation rose 8.5 percent compared with the year before.

Many Fed leaders have said they want to front-load more-aggressive hikes now and in the coming months, to make progress curbing inflation before it is too late. Powell said policymakers weren’t “actively considering” even stronger hikes of three-quarters of a percentage point for now, but he did hint there could be more half-percentage-point hikes at the next couple of Fed board meetings.

Higher interest rates could help, Powell says. Not everyone agrees.

The Fed’s message has long been that it needs to respond to what’s happening in the economy. Michael Strain, director of economic policy studies at the American Enterprise Institute, said that given so much uncertainty, the Fed shouldn’t narrow its options for how forcefully it can respond, especially if inflation remains elevated.

“I’m not saying that the Fed should raise by 75 [basis points] in June, but what if we get 10 percent [inflation levels in the consumer price index] next week?” Strain said. “Then the discussion is going to be about whether we could put 75 back on the table. All you’re going to get is tons more volatility out of it.”

The Fed also announced it will start scaling back its nearly $9 trillion balance sheet in June, moving at a quicker pace than the last time the Fed shrank its portfolio, several years after the Great Recession. The Fed will shrink its balance sheet by up to $30 billion in Treasury securities and $17.5 billion in agency mortgage-backed securities in June, July and August. Then later this year, another $60 billion in Treasurys and $35 billion in mortgage securities will also come off the Fed’s balance sheet.

Inflation has been a scourge on an economy that appears strong by several other measures. The U.S. economy has added 1.7 million jobs this year. Consumer spending is strong, and wages are rising. The Biden administration often touts this progress as hard to fathom when the pandemic began.

However, higher costs for rent, clothing and utilities increasingly dominate how people are feeling about the economy, and have made it harder for the Biden administration to rally support for its economic message. And though inflation is the purview of the Fed, it has weighed heavily on President Biden’s approval ratings, even while the administration touts its own steps to lower gas prices and ease other inflationary pressures.

Rents are rising everywhere. See how much prices are up in your area.

Republicans are hammering Democrats on the economy going into the 2022 midterms, arguing that sweeping stimulus spending last year sent the economy into overdrive. Republicans also say the Fed waited too long to respond to inflation and hike rates.

Even as prices began to creep up last spring, Fed officials initially dismissed the increases as “transitory,” or temporary, and waited to start raising interest rates until mid-March, wary that any earlier intervention would slow progress in the labor market.

But that worry quickly reversed itself. The labor market has remained strong, with unemployment falling to near-record low of 3.6 percent in March. The high demand for workers has brought about higher wages and more bargaining power. But the job market is so tight, employers across several industries are still dealing with worker shortages.

Powell reiterated that higher interest rates might be able to help alleviate the tight labor market, as well, if employers scale back on the number of workers they need.

“There are 1.9 vacancies for every unemployed person,” Powell said at the news conference. “It seems as though by moderating demand, we could see vacancies come down, and as a result — and they could come down very significantly — put supply and demand at least closer together than where they are.”

U.S. markets jumped on news of the Fed rate hike. The Dow Jones industrial average gained 932 points, or 2.81 percent, to finish at 34,061. The S&P 500 index climbed 125 points, or 3 percent, and the Nasdaq grew 401 points for nearly 3.2 percent.

The gains begin to reverse the market’s sour trend in April, which was the worst month for the S&P 500 since March 2020 and capped its worst start to the calendar year since World War II. Persistent inflation and the threat of rising interest rates hammer tech stocks, which power the many indexes. But investors said any move by the Fed to tame inflation could boost the short-term economic outlook.

“Markets got what they asked for today,” said Charlie Ripley, senior investment strategist at Allianz Investment Management. “With little signs of inflation cooling, the Fed has its sights on bringing the policy rate to a more neutral level in a relatively short order. With inflation running as hot as it has been, what really matters for the Fed is where they are headed, not so much how they get there.”

Jacob Bogage contributed to this report.