Anxious Fed set for historic measure to try to curb inflation

Anxious Fed set for historic measure to try to curb inflation
Jerome H. Powell, Nominee to be Chairman of the Board of Governors of the Federal Reserve looks on during a Senate Banking, Housing and Urban Affairs confirmation hearing on Capitol Hill, in Washington D.C., Tuesday, January 11, 2022

The Federal Reserve is set to take its most aggressive action in decades to rein in inflation when it meets this week — a move that would have implications for the entire economy.

The Federal Open Market Committee, which dictates the country’s monetary policy and is led by Fed Chairman Jerome Powell, is expected to hike its interest rate target by half a percentage point in order to drive down inflation when it meets next Tuesday and Wednesday.

A half-point increase, also known as a 50-basis-point hike, is akin to conducting two interest rate hikes at once, given that the federal funds rate is typically moved up by a quarter of a percentage point at a time. If the Fed follows through on the more aggressive hike, it would be the first time such an action has been taken in more than two decades.

Investors place the likelihood of the more aggressive rate hike occurring at more than 96%, according to CME Group’s FedWatch tool, which calculates the probability using Fed fund futures contract prices. Most investors are also predicting two more half-point hikes in June and July.

The situation the Fed finds itself in is historic. Consumer prices rose a staggering 8.5% for the 12 months ending in March, the fastest rate since 1981. In addition to hiking interest rates, the Fed is also likely to begin shrinking its balance sheet by $60 billion in treasuries and $35 billion in mortgage-backed securities each month.

Desmond Lachman, a senior fellow at the American Enterprise Institute, told the Washington Examiner that the central bank will have a difficult time threading the needle of dampening inflation while trying to avoid a recession.

Further fueling recession fears, the yields — that is, the rate of earnings generated by the security over time — on certain shorter-run Treasury notes have at times in recent weeks risen higher than those on certain longer-run notes, a situation that is called an "inversion." The sign means that investors believe inflation won’t be a problem over the long run because the economy is going to enter a recession.

The share of economists predicting a recession is on the rise, with nearly 30% predicting one in the next year in a survey conducted by the Wall Street Journal.

Rep. Kevin Brady, the top GOP tax writer, said on Wednesday that there is “no question” that the Fed’s policies under Powell were a major contributor to today’s soaring inflation. The Texas lawmaker said the Fed has put itself into a pickle by not using its monetary policy to tamp down demand sooner.

“I think the Fed is in a difficult position of their own making, it will be incredibly difficult to thread the needle here, and unfortunately, they created these circumstances through their inaction last year,” Brady told the Washington Examiner during a call with reporters.

Lachman said that consumers shouldn’t expect much of a tone shift from the Fed following its meeting this week because the central bank has tried to message what it plans to do in advance of taking policy action. Markets have also already priced in a half-point hike.

Just because the Fed is now moving aggressively against inflation doesn’t mean consumers will see prices slowing right away. Lachman said that much monetary policy operates with fairly long legs, meaning that prices are expected to keep increasing at a higher rate than wanted throughout the year. Still, inflation could start to decrease quicker if the economy ends up sinking into a recession.

Consumers will see the tangible effects of the interest rate hikes most prominently in the housing market. As of Wednesday, the average 30-year fixed-rate mortgage was 5.3%, up more than 2 percentage points from just a year before. The higher rates are making housing less affordable.

As for how history will judge the current situation, Lachman said that the current Fed will be judged “very badly” for its actions on inflation.

He thinks that history will come down favorably on Powell’s actions early in the pandemic, when he acted to pump liquidity into the market and slashed interest rates, but that the Fed’s actions over the last year will be scrutinized.