The Federal Reserve is expected to announce the biggest interest rate hike since 1994 on Wednesday after an alarming inflation report and a stock market meltdown upended the central bank’s plans.
The Federal Open Market Committee (FOMC), the panel of Fed officials responsible for setting monetary policy, was on track to announce a 0.5 percentage point hike to its baseline interest rate range at the end of its two-day meeting Wednesday. It would have been the second 50 basis point hike issued by the FOMC in consecutive meetings as the bank struggles to get ahead of rising prices.
But Fed watchers now believe the FOMC will hike rates by 75 basis points for the first time in decades after a tumultuous two-day stretch for financial markets and the economy at large.
Consumers and businesses have become increasingly concerned about the state of the economy and expect inflation to keep rising above current levels, which can serve as a self-fulfilling prophecy without quick Fed action.
“Not only is the Federal Reserve faced with the risk of inflation becoming embedded into consumer and business expectations, but it must also factor market behavior into its policy decisions,” said Joe Brusuelas, chief economist at tax and audit firm RSM, on Tuesday.
Brusuelas is one of scores of economists who expected the Fed to hike rates by 50 basis points up until Monday’s stock market meltdown prompted greater concern among investors and experts.
“The question for policymakers becomes to what degree the financial sector will be directly or indirectly affected by those swings and how best to mollify that exposure,” he continued.
“We now call on the central bank to hike rates in such a way to restore investor confidence and maintain well-anchored medium to long-run inflation expectations.”
Stocks cratered and bond yields spiked Monday as investors became increasingly concerned with how the Fed would respond to a surprising May inflation surge.
The S&P 500 index slipped back into a bear market — down 20 percent from its most recent record high — and the Nasdaq and Dow Jones Industrial Average fell deeper into their own steep downturns.
Investors appeared to sour over the weekend after the Labor Department announced Monday that prices rose 1 percent in May alone and by 8.6 percent over the past 12 months. Inflation rose rapidly last month largely due to the war in Ukraine’s impact on energy and food prices — a threat largely beyond the Fed’s control, but with serious obstacles for their fight for price stability.
The inflation surge came as the economy was already feeling the impact of higher borrowing costs set by the Fed. Home sales and housing demand has plunged amid rising mortgage rates, stocks had already fallen significantly from record highs set last year and retailers were bracing for steep declines in sales of goods with prices already inflated by supply chain snarls.
Altogether, those forces should have been somewhat encouraging signs of the economy adjusting to higher borrowing costs. But the steadiness of inflation — and how far it has spread through the economy — caused greater alarm about how well the Fed was curbing price growth and whether the economy can handle it.
“It’s an enormous conundrum right now as to whether or not the Fed should honor what’s priced into the market clearly,” said Daniel Alpert, managing partner of investment firm Westwood Capital.
Financial markets are all but certain the Fed will announce a 75 basis point interest rate hike, according to the CME Group FedWatch tool, which monitors where futures tied to the Fed’s baseline interest rate range are trading. Based on market pricing, the FedWatch tool gave a 97 percent chance of a 75 basis point interest rate hike on Wednesday.
A steeper interest rate hike would have an immediate impact for borrowing costs on credit cards and other shorter-term loans tied directly to the Fed’s baseline interest rate range. It would also likely keep up pressure on mortgage rates and other longer-term loans, which move in line with Treasury bond markets.
Higher borrowing costs would ideally slow the rate of price growth by slowing spending on goods and services already in high demand. But the pace of interest rate hikes necessary to tame inflation has stoked concern among many analysts that the Fed could push the U.S. into recession.
“Over the last month we have argued that market pricing was in roughly the right place in the sense that the drag from tighter financial conditions, in conjunction with the sizeable fiscal drag this year, puts the economy on the somewhat below-potential growth trajectory that we think is needed to rebalance supply and demand,” wrote analysts from Goldman Sachs in a Tuesday note.
But they fear that if market expectations hold true and the Fed’s baseline interest rate range rises to a midpoint of 4 percent by the end of the year, economic growth would slow to a point well beyond “bringing down inflation without a recession.”