Fed Continues Its Battle with Inflation

On May 4, FOMC members voted to raise the Fed Funds Rate by 50 basis points, or 0.50%. This was the second time that the Fed has raised rates in 2022, and these rate increases are a significant deviation from the accommodative policy position they maintained in the first two years of the pandemic. Further rate increases are likely in 2022, as the Fed continues to battle persistently high inflation.

Interest Rates Up, Balance Sheet Down

At May’s meeting, the Fed raised the Fed funds rate by 50 basis points. The new target range for the Fed funds rate is 0.75%-1.0%.

In addition to raising rates, the FOMC will implement a plan to reduce the size of the balance sheet, beginning on June 1. During the COVID-19 recession and the following months, the Fed engaged in quantitative easing. Now that portions of the economy have recovered, the Fed has ended the quantitative easing program and will seek to unwind some of those purchases.

Going forward, the Fed will adjust its balance sheet by limiting reinvestments. Starting June 1, only principal payments that exceed the monthly cap will be reinvested. For Treasuries, the initial cap will be set at $30 billion per month and that will be increased to $60 billion after 3 months. For agency and mortgage-backed securities, the cap will be initially set at $17.5 billion per month and increased to $35 billion after 3 months.

Several Factors Led to the Interest Rate Increase

In the past, the Fed has often raised rates in 25 basis point increments. However, the current inflation environment is a large contributor to their more aggressive policy decision. Recent data shows that consumer prices rose by an annual rate of 8.5% in March. This represents the fastest pace of inflation since December 1981 and a significant concern for the economic outlook – should the inflation persist.

Raising rates is a common method used by the Fed to tame inflation, but there is often a concern that adverse consequences will outweigh the benefits. One of these adverse consequences is a slowing economy, because slowing economies typically lead to higher unemployment. However, unemployment has normalized from the highs seen during the pandemic and fell to 3.6% in March. By historical standards, this is a very low unemployment rate, and many believe that the tight labor market could withstand a shock.

In addition to higher unemployment, raising rates can also slow economic growth. By most measures, the economy has recovered from the COVID-19 recession and the subsequent market turbulence. However, real GDP declined by 1.4% in the first quarter, following a strong increase of 6.9% in the fourth quarter of 2021.

The FOMC noted that while GDP fell in the first quarter, household spending and business fixed investment remained strong. Overall, many attribute the loss in GDP early in the year to higher prices, continuing supply chain difficulties, and geopolitical concerns. So, there is evidence to suggest that the potential benefits of raising rates to tame inflation could outweigh the risks to GDP.

Other factors, such as the Russia-Ukraine conflict, and continuing COVID-19 lockdowns in China, also impacted the FOMC’s decision. These situations could lead to higher inflation in the future and make it more important than ever for the Fed to continue its intervention.

2022 Interest Rate Outlook

The Fed’s battle with inflation is far from finished, and many expect rates to continue to climb throughout the year. In fact, Fed funds futures traders expect another rate hike in June with 78% probability.

According to FOMC projections released in March, FOMC members expect the Fed funds rate to reach 1.9% by the end of the year and climb to 2.8% by the end of 2023. However, many economists and traders expect even swifter action. Fed funds futures traders show a 99.5% probability that the Fed funds rate will reach or exceed 2.0% by the end of the year and 40.3% probability that rates will reach or exceed 2.5%.

The course of interest rates will likely depend on how the various parts of the economy react to rate hikes, the most prominent of these being consumer prices. If inflation continues to be an issue, it could lead the Fed to raise rates more quickly. On the other hand, if higher rates weigh on economic growth or employment, the Fed could dial back their efforts. Finally, with the abundance of geopolitical turmoil, only time will tell if rate hikes will be effective at reducing prices. If rate hikes fail to tame inflation, the Fed could face one of the most difficult economic challenges in modern times.

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