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Fed Expects Rate Hikes by Late 2023

Fed Expects Rate Hikes by Late 2023

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The Federal Open Market Committee announced on Wednesday expectations to raise interest rates up to 0.6% by late 2023 in response to concerns over high inflation and accelerating growth during the post-pandemic economic recovery.

This marked a reverse course from its previous statement in March that the Fed expected to keep interest rates near zero through the end of 2023 in order to encourage spending and to expedite the economic recovery. However, post-COVID economic recovery data has shown an exceedingly tight labor market, anxiety over asset prices, and high inflation; these indicators have changed the Fed’s forecasts of its future policies.

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Recent consumer price index (CPI) data as of May 2021 indicated a 5.0% rise in inflation in the past year, the highest annual rate since 2008; similarly, the Fed's preferred inflation gauge, the personal consumption expenditure price index (CPE), jumped to 3.6%--its highest since July 1992. Fed Chairman Jerome Powell has previously stated that this high inflation is transitory, as the reopening of the economy has witnessed a simultaneous surge of pent-up demand and supply chain bottlenecks, and will not necessitate an immediate rate change.

Yet, after its two-day policy meeting, the committee found imminent concerns about inflation, as policymakers expect inflation to rise to 3.4% in the fourth quarter of 2021 from the past year, an increase from the initial 2.4% projection in March. If inflation remains higher than the target average of 2%, firms and consumers may anticipate even higher inflation in the future, paving the way for a self-fulfilling prophecy. If inflation does become a long-term concern, the Fed will tighten economic policy accordingly through interest rates and balance sheet management to rein in excessive borrowing and spending.

However, the Fed can afford some flexibility in their economic policy, as in August 2020, Powell announced the Fed adjustment to their inflation policy: instead of using monetary policy to achieve a target inflation rate of 2%, the central bank would aim for an long-term average rate of 2%, allowing for flexibility in the central bank’s expansionary monetary policy. This is a shift from inflation-hawkish to dovish, as the Fed is now prioritizing unemployment and economic growth over the tight maintenance of a 2% inflation rate.

This new outlook allows the Fed to engage more freely with expansionary monetary policies such as quantitative easing through its monthly $120 billion purchase of Treasury and mortgage bonds to increase the money supply (in a process known as open market operations). It serves as one of the main tools that the Fed has to create liquidity and to maintain their target interest rate. After its two-day policy meeting, the Fed signaled that it expects to maintain “accommodative” policies by continuing their bond purchases until “substantial further progress has been made toward maximum employment and price stability goals.”

As the economy rapidly recovers in the coming months, the Fed will move to both scale back its bond-buying program (to slow the increasing money supply) and raise rates in order to mitigate potential overheating and regulate inflation.

While the Fed ultimately maintains that the inflation is transitory, attributing inflation to supply bottlenecks (e.g. lumber and semiconductors) and the rise in prices in the quickly reopening leisure industry (e.g. admission tickets, airfare, hotels, and rental cars), others are betting on the possibility that inflation is here to stay. Jamie Dimon, CEO of JPMorgan Chase, signaled on Monday that the firm has been “effectively stockpiling” cash, as it bet on the Fed raising interest rates (and thus a fall in asset prices) in response to high inflation. This would allow them to both lend at higher rates and to buy equities at bargain prices. 

In response to the Fed’s new projection of two rate hikes in 2023, market indexes edged lower but recovered some ground toward market close. The S&P 500 fell 0.54%, while the Dow Jones lost 0.77%, indicating that fund managers and other investors have expected such actions and have priced them in.

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