3, 2, 1...Liftoff: The Federal Reserve Begins the Inflation Fight

Jeffery Tanguis
March 17, 2022

The Federal Reserve has begun the monumental task of reigning in soaring inflation in the United States. The world’s leading central bank announced it raised its target rate range by 0.25% to 0.25%-0.50%, the first rate increase since 2018. The rate hike may sound small but it represents an important shift in Fed policy. The policy move is the first in a “series” of likely increases necessary to slow consumer demand in the U.S. economy and curb rising inflation. The increases are expected to occur over the balance of 2022 and into 2023.

This shift will have gradual but far reaching implications as the rate increases filter throughout the financial system. Eventually interest rates on everything from money market funds to home mortgage rates will likely be impacted.

 

The Federal Reserve Begins the Inflation Fight

 

The Path Forward

Fed Chairman Powell laid out with unusual clarity the path ahead for its target interest rates. In the post meeting press conference commentary, Powell indicated the committee is leaning toward raising rates by 0.25% at each of the 6 remaining Fed meetings this year. Further supporting that view is the Fed policy committee’s updated forecasts of future rate hikes (casually referred to as the “Dot Plot”) which also points to 6 additional rate hikes this year as well and 3 to 4 more hikes next year. Today’s events signal a Fed that intends to hike rates faster and higher than previously anticipated. Ultimately, the Fed seeks to return interest rates back to “normalized” pre-pandemic levels. Powell said the Fed expects inflation should begin to decline in the second half of this year, then come down “more sharply” next year. Chairman Powell also downplayed the chance of recession in the near term.

 

Shrinking the Balance Sheet

Over the course of the last 2 years the Fed stimulated the economy by purchasing Treasury and Agency mortgage-backed securities in the open markets in a process known as “Quantitative Easing” (QE). QE injected cash into the economy, lowered longer-term interest rates on things like home mortgages and was a major driver of the residential housing market boom. The Fed purchased nearly half of all new mortgages created since the pandemic started. Overall, the massive purchases during the pandemic doubled the Fed’s balance sheet to almost $9 trillion. 

Powell’s post meeting commentary today indicated that the committee began discussion of using the reverse process, known as “Quantitative Tightening” (QT), to remove unnecessary economic stimulus and slow the economy. This process allows a portion of purchased securities to mature and roll off of the balance sheet over time. The Fed could elect to outright sell securities to shrink the balance sheet more quickly if inflation proves persistent but that appears unlikely at this time. The net result of QT will likely be that intermediate and longer term interest rates trend higher over time toward more normal pre-pandemic levels and bond markets resume functioning normally. More details of the Fed’s QT plans will likely be available when the Fed releases the minutes of today’s meeting on April 6.

 

How does the Russia/Ukraine War impact the Fed’s plan?

Chairman Powell emphasized that the U.S. economy is not insulated from the economic fallout surrounding the conflict in Ukraine. Elevated commodity prices and slower global growth related to the economic sanctions imposed on Russia raises risks to the U.S. outlook for both economic growth and inflation. This uncertainty might warrant the Fed moving slower than otherwise in raising interest rates should the conflict drag on for a protracted period.

 

Final Word

Chairman Powell knows the Fed faces a critical challenge ahead. On one hand, supply chain bottlenecks, skyrocketing commodity prices and tight labor markets have led to the highest inflation rates in 40 years. This means the Fed must act decisively or risk having high inflation expectations entrenched in the consumer’s mindset. On the other hand, the U.S. economy is already on a glide path to slower, more normalized growth, and the Fed must be nimble and careful to avoid abrupt policy overcorrections that might douse economic growth. Add in the Russia/Ukraine uncertainty and the Fed is left with a fairly tight window through which to pilot a soft landing for the U.S. economy on its way to containing inflation. Chairman Powell and his policy committee were widely applauded for their skillful handling of the U.S. economy in the early days of the pandemic. Powell now faces another important test. Hopefully his experience will guide him through yet another challenge.