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The Federal Reserve is poised to step up its war on inflation this week with another huge interest rate hike, risking a deeper recession when the US economy is already slowing.
With inflation unexpectedly accelerating to a new 40-year high in June and the labor market continuing to grow at a healthy pace, the Fed is under increasing pressure to act more aggressively to rein in demand and curb the increase in consumer prices.
But there are signs that the economy is starting to cool: The number of Americans filing for unemployment benefits has gradually increased, companies have announced layoffs or hiring freezes, and the housing market is softening. Gross domestic product slowed in the first quarter of the year by 1.6% and is expected to decline again in the second quarter.
Despite this, Fed policymakers remain focused on controlling inflation, as higher prices are persistent, even if they trigger a recession. Fed Chairman Jerome Powell told reporters last month that failing to restore price stability would be a “bigger mistake” than crushing growth and causing a crash.
HOW HOUSING ACTIVATES HOT INFLATION
Federal Reserve Chairman Jerome Powell speaks to the Senate Banking, Housing and Urban Affairs Committee as he delivers the Monetary Policy Report to the committee on Capitol Hill, Wednesday, June 22, 2022, in Washington. (AP Photo/Manuel Balce Ceneta/AP Newsroom)
“The Fed will continue on its very aggressive path of rate hikes to fight inflation, which has been so devastating to American families,” said Dan North, senior economist at Allianz Trade North America. “But in doing so, the Fed is actually putting the brakes on the economy, increasing the risk of recession.”
Central bank policymakers raised the benchmark interest rate by 75 basis points in June for the first time since 1994 and signaled that another increase of this magnitude is possible in July.
Inflation was even higher than expected last month, with the consumer price index, a broad measure of the price of everyday consumer goods including gas, groceries and rent, rising a 9.1% in June compared to a year ago. Mark the faster rate of inflation since December 1981.
In an even more alarming development, so-called core prices, which exclude the more volatile measures of food and energy, rose 5.9% from a year earlier. Core prices also rose 0.7% month-on-month, higher than in April and May, suggesting that inflation is becoming increasingly sticky as it spreads throughout the economy.
A man wearing a mask walks past the US Federal Reserve Building in Washington DC on April 29, 2020. ((Xinhua/Liu Jie via Getty Images) / Getty Images)
Given the dismal inflation report, the Fed is expected to impose a second rate hike of three-quarters of a point after Wednesday’s two-day meeting. That would mark the fourth straight hike since March and put the key rate in a range of 2.25% to 2.5%, the highest since the COVID-19 pandemic began more than two years ago.
WHY IS INFLATION SO HIGH AND WHEN DOES IT START TO COOL?
But a 100 basis point rate hike could also be on the table: Investors raised their expectations for a sizeable rate hike after the scorching Labor Department report, with about one in four traders who made a full percentage point increase. It would be the first rate hike of its size since the Fed began announcing moves in the overnight federal funds rate in 1994 and would place the benchmark range between 2.5% and 2.75%.
Rising interest rates tend to create higher rates for consumer and business loans, which slows the economy by forcing businesses to cut spending. Mortgage rates are already nearing 6%, the highest since 2008, while some credit card issuers have raised their rates as high as 20%.
Policymakers have remained confident they can slow growth enough to tame inflation without dragging the economy into recession. But experts are increasingly skeptical that the Fed can pull off that kind of outcome, often referred to as a “soft landing.”
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That’s partly because at least some of the inflationary pressures come from unexpected supply disruptions like the Russian war in Ukraine and the COVID-19-related lockdowns in China. While the Fed can control demand, it does not have the necessary tools to address supply.
“Fed policy cannot directly affect food or energy inflation, while rate hikes so far have done little to dampen core CPI components, which are traditionally more sensitive to monetary policy,” he said Seema Shah, Chief Global Strategist at Principal Global Investors. “As such, the Fed must continue to walk aggressively if it wants to control the inflation problem, even if that means accelerating a recessionary problem.”