Interest Rates are on the Rise

A chart depicting interest rates rising

Yesterday, FOMC members raised interest rates for the first time since the pandemic began. In addition, they submitted their economic projections for the short- and intermediate-term. This rate hike represented the first increase since the onset of the pandemic and a significant change to the economic landscape. Business leaders who understand this new rising rate environment can avoid costly decisions and take advantage of the opportunities it presents.

FOMC Announces First Interest Rate Hike in Pandemic Era

In March 2020, the Fed lowered the Fed funds rate to its effective lower bound, a target rate between 0% and 0.25%, and rates had remained at this level since the onset of the pandemic. Then, at yesterday’s FOMC meeting, the board announced the first interest rate hike in 2 years.

Following their meeting, the FOMC announced that the Fed funds rate will rise by a quarter of a percent, bringing the target range to 0.25%-0.5%. In addition to raising rates, the board noted that it expects to soon begin reducing its holdings of Treasury and agency debt. These securities were purchased under the quantitative easing program that began during the pandemic. Both raising rates and reducing the size of the balance sheet are intended to lower inflation.

What Factors Led to Rising Interest Rates?

Economic output, employment, and inflation all contribute to the FOMC’s policy decisions. Currently, economic output and employment are showing signs of strengthening from pandemic lows, while inflation has reached a multidecade high. Together, these factors propelled the FOMC’s rate decision.

Economic Growth

Higher interest rates can dampen consumer demand, leading to lower economic output. For this reason, the Fed considers the current level of Gross Domestic Product [GDP] when deciding on appropriate monetary policy. When output is growing, it can signal that the economy can withstand the potential impact of higher rates.

In the current environment, economic output is strong. In 2021, Real GDP grew by 5.7% following a 3.4% decline in 2020. This data shows that economic output has recovered from pandemic lows and could indicate that the economy is able to withstand higher rates. However, geopolitical tensions continue to be a significant risk factor which could influence the Fed’s policy decisions going forward.

Employment

Higher interest rates can negatively impact the labor market, so the Fed takes the current state of employment into consideration when making policy decisions. In February, the unemployment rate fell to 3.8%, down significantly from its high of 14.7% in April 2020. Prior to the pandemic, unemployment was very low, at just 3.5%.

While unemployment remains above the pre-pandemic level, the current level is low by historical standards. This indicates that the labor market might withstand higher interest rates while the Fed combats inflation.

Inflation

Moderate inflation is seen as a necessary byproduct of a strong economy. That’s why the Fed’s long-term goal for inflation is 2%. However, inflation rates above the Fed’s target can pose a significant risk to the economy.

The annual inflation rate reached 7.9% in February, the fastest pace of inflation since January 1982 and far above the Fed’s target. Core inflation, which excludes the volatile food and energy sectors, also reached a multidecade high. From February 2021 to February 2022, core inflation rose 6.4%, the largest 12-month change since August 1982.

Inflation began rising during the pandemic when supply chains and production were disrupted by uneven global shutdowns. At that time, Fed officials and many economists believed that price increases would be transitory and limited to the sectors most impacted by the pandemic. However, prices have continued to increase across the board, even as many countries resume normal operations.

When prices increase across the economy, Fed intervention is often necessary to bring inflation down to a more moderate level and prevent stagflation. For this reason, the current inflation environment was a key driver in the FOMC’s decision to raise rates.

What Factors Tempered the Fed’s Aggressiveness with the Initial Rate Hike?

With inflation at a forty-year high, many expected the Fed to take more drastic action with interest rates. Early in 2022, markets were predicting a 0.50% increase. However, the current geopolitical tensions have created additional risk to the U.S. economy which factored into the FOMC’s decision to approve a more modest initial rate hike.

The geopolitical climate featured prominently in the FOMC’s statement. On Russia’s invasion of neighboring Ukraine, the FOMC said, “[t]he implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity.”

Though economic output and employment have shown signs of recovery from the pandemic, recent geopolitical tensions could alter that course. Since higher interest rates can also dampen output and the labor market, the Fed must proceed cautiously with rate increases in this uncertain environment.

FOMC Members See More Interest Rate Hikes on the Horizon

FOMC members submitted their updated economic projections at the March meeting. These forecasts indicate where FOMC members see economic output, employment, and inflation over the next three years and in the longer run. Additionally, members indicate what policy rate they see as being appropriate each year. Since the last update in December, forecasts have shifted dramatically.

Economic Projections for 2022

FOMC members lowered their estimates for economic growth in 2022 from 4.0% to 2.8%.  This indicates that FOMC members expect economic output to grow this year but at a more moderate pace than was previously expected.

While estimates for economic growth fell, projected inflation rose from 2.6% to 4.3%. With higher inflation expectations, the FOMC’s projected Fed funds rate also increased dramatically from 0.9% to 1.9%. On the other hand, estimates for unemployment held steady at 3.5%.

Economic Projections for the Longer Term

In the longer-term, FOMC members’ projections were little changed. For GDP in 2023 and 2024, estimates remained the same at 2.2% and 2.0%, respectively. After 2024, GDP is expected to grow at a more moderate 1.8%.

Inflation

Projections for inflation over the coming years moved higher with inflation expected to be 2.7% in 2023 and 2.3% in 2024. Longer run, inflation is expected to normalize at the Fed’s target of 2.0%.

Interest Rates

With higher inflation, forecasts for the Fed funds rate also rose. By year end 2023, the Fed funds rate is projected to reach 2.8% where it is expected to remain through 2024. Longer run, FOMC members anticipate a Fed funds rate of 2.4%.

Unemployment

Unemployment is expected to remain steady over the coming years with an anticipated unemployment rate of 3.5% in 2023 and 3.6% in 2024. Longer run, unemployment is expected to grow to 4.0%.

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