Lift Off

The Federal Open Market Committee (FOMC) voted to raise the fed funds rate by a quarter point from .25% to .5%, the first increase in short-term interest rates since 2018. St Louis Federal Reserve President Jim Bullard dissented, pushing for a half percent hike.

The statement released at the press conference following the decision underscored that rate hikes will be “ongoing” and that a decision to shrink the balance sheet is imminent. FOMC members made progress on how they plan to reduce the balance sheet; expect an announcement to shrink the Fed’s mammoth balance sheet in May.

The dot plot, which provides participants’ views about the economy prior to the meeting, shows they expected weaker growth and more inflation than just three months ago. The unemployment rate remained unchanged, at 3.5% in 2022 and 2023. That seems fanciful, given a weak first quarter.

The consensus around rate hikes is six, double the pace of rate hikes in December. That is in addition to the March hike. The devil is in the details; seven of the 17 participants now expect eight rate hikes, with at least one hike of half a percent. Seven more have seven rate hikes while the remaining three show less than that. This is a significantly more hawkish Fed, focused on forcefully reining in inflation.

Our own analysis suggests that seven rate hikes, coupled with the crimp on spending triggered by the surge in prices associated with the war in Ukraine, would bring growth down below 1% in the second half of the year. That is not enough to keep the unemployment rate from rising. Additional rate hikes could easily trigger a recession.

The Fed expects to continue to raise rates in 2023. Two expect the fed funds rate to hit 3% in 2023 and remain there in 2024. That would be the highest short term rates we have seen since the onset of the financial crisis in 2008.

Chairman Jay Powell pushed back on that view, arguing that the risk of recession remains low. He underscored that he believes that the strength of the labor market can keep the economy humming. Robust job gains were not enough to keep consumers spending during February. Retail sales disappointed for the month in response to the bite of higher prices across the board. Overall growth in the first quarter looks like it could come in at less than 1%.

The Fed is clearly much more worried about inflation than it was just a few months ago. Powell highlighted uncertainty about how the war in Ukraine might affect growth but the emphasis was on the impact it has on inflation.

Powell said that he expects inflation to come down in the second half of the year, in part due to what are known as “base effects.” High inflation a year ago will temper year-over-year measures of inflation in the second half of the year. That was supposed to have already happened but it hasn’t. The Fed now expects inflation to remain hotter for longer.

He was careful to say the Fed would monitor the momentum on inflation month-to-month. This is key if the Fed truly wants to cool the economy and avert a more prolonged and entrenched inflation or worse - stagflation.

Bottom Line
The FOMC has begun a series of rate hikes and appears willing to do the heavy lifting necessary to rein in inflation. Members think they can do that without triggering a recession. There is no history of doing that with the kind of inflation we are currently seeing.

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