WASHINGTON — Conflicting signs about the health of the US economy have put the Federal Reserve in a difficult spot.
With inflation at a four-decade high, the labor market strong and consumer spending still solid, the Fed is under pressure to raise interest rates aggressively.
But other signs suggest the economy is slowing and may even have contracted in the first half of the year. This evidence would normally lead the Fed to stop raising rates, or even cut them.
For now, however, the Fed is squarely focused on its fight against inflation and will announce another sharp hike in its benchmark interest rate this week. Along with its previous rate hikes, the Fed’s moves will make borrowing more expensive for individuals and businesses and will likely weaken the economy over time.
“Until there is very clear evidence that the labor market is starting to deteriorate significantly, the Fed’s No. 1 focus has to be inflation,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank.
When its final policy meeting ends on Wednesday, the Fed is expected to impose a second straight hike of three-quarters of a point, lifting its key rate to a range of 2.25% to 2.5%. It will be its fourth rate hike since March, when it announced a quarter-point increase. Since then, with inflation hitting new four-decade highs, the central bank has cut credit ever more aggressively.
By raising borrowing rates, the Fed makes it more expensive to get a mortgage or a loan for a car or business. In turn, consumers and businesses will likely borrow and spend less, cooling the economy and curbing price increases. The Fed’s hikes have already led to a doubling of the average rate on a 30-year fixed mortgage last year to 5.5%, and home sales have fallen. The central bank is betting it can slow growth just enough to control inflation, but not enough to trigger a recession, a risk many analysts fear could end badly.
Fed rate hikes are not adequate to address all the causes of high inflation. Higher borrowing rates can reduce spending. But they cannot reverse other factors, notably global shortages of food, energy, factory parts and other items, which have been exacerbated by Russia’s war on Ukraine and China’s COVID-19-related shutdowns .
It will also likely take months for the Fed’s higher rates to reduce spending on airline flights, restaurant meals and other services. Many economists worry that this means the Fed will have to further clamp down on consumer and business demand, to balance it with the economy’s tight supply of goods and labor.
A news conference that Chairman Jerome Powell will hold on Wednesday, and any signal he sends, if any, about the Fed’s next steps will be of intense interest. Since the Fed met in June, the government has reported that inflation accelerated to an annual rate of 9.1%, the highest since 1981. Although that jump reflected a rise in gas prices , which have since declined, inflation worsened even after excluding the volatile energy and food categories.
The national jobs report for June showed that hiring remained healthy, with employers adding 372,000 jobs last month. Employers’ continued need for labor has pushed up wages and contributed to inflation as businesses pass on their higher labor costs to customers in the form of price increases.
Interestingly, however, despite the strong labor market and its role in keeping inflation high, by some measures the economy is barely growing, if at all. When the government reports on growth in the April-June period on Thursday, it may show that the economy contracted for the second consecutive quarter.
Although two consecutive quarters of negative growth are sometimes considered an informal definition of a recession, few economists think the economy is in crisis. Instead, recessions are defined by the National Bureau of Economic Research, a nonprofit group of economists. The NBER evaluates a wide range of data to determine recessions and gives heavy weight to income and jobs. Economists note that employers have added 2.7 million jobs so far this year, pointing to an economy far from recession.
If, as expected, the Fed raises its short-term rate this week to 2.25% to 2.5%, it would put it near a level that officials believe neither stimulates nor discourages the growth After that, policymakers could raise the rate in smaller increments to levels that would slow the economy. Fed officials have indicated they expect to raise it to a range of 3.25% to 3.5% by the end of the year.
On Wednesday, Powell is expected to reiterate the Fed’s determination to raise rates until inflation falls, even at the risk of slowing growth too much.
“What we’re looking for is strong evidence that inflationary pressures are easing and that inflation is coming back down,” he told a news conference after the Fed’s June meeting. “We would like to see this in the form of a series of monthly inflation readings falling.”
At a central banking forum last month in Portugal, Powell added: “Is there a risk that we go too far? Certainly there is a risk, but I would not agree that this is the biggest risk to the economy . The biggest mistake to make … would be not to restore price stability.”
Other officials have made clear they expect the Fed to continue raising rates for the foreseeable future.
“I haven’t seen any compelling evidence that inflation has turned the corner,” Loretta Mester, president of the Federal Reserve Bank of Cleveland, said earlier this month.
Still, conflicting signals from the economy have dogged Fed policy for months, with many analysts calling for a clearer message. In June, policymakers had indicated a half-point rate hike was likely, until just before their meeting, when expectations abruptly changed to a three-quarter point hike.
And after June’s inflation report showed price increases were accelerating, Wall Street traders bet the Fed would impose a full percentage point hike this week. That expectation also faded after several Fed officials rejected the idea. The rapid rise in expectations was “borderline ridiculous,” Krishna Guha, an economist at Evercore ISI, an investment bank, wrote to clients.
Policymakers should “become a bit more flippant about how they see the pace of rate hikes going forward,” said Ellen Meade, a professor of economics at Duke University and a former senior Fed economist. “Will they react to a dramatic slowdown in the economy if that has to happen before they see inflation decelerate in a meaningful way? Having a little more insight into how they think about that might be helpful.”