The Federal Reserve raised interest rates by the steepest increment since 2000 and decided to start shrinking its massive balance sheet, deploying the most aggressive tightening of monetary policy in decades to control soaring inflation.
The US central bank’s policy-making Federal Open Market Committee on Wednesday voted unanimously to increase the benchmark rate by a half percentage point. The Fed will begin allowing its holdings of Treasuries and mortgage-backed securities to roll off in June at an initial combined monthly pace of $47.5 billion, stepping up over three months to $95bn.
“The committee is highly attentive to inflation risks,” the Fed said in the statement, adding a reference to Covid-related lockdowns in China that “are likely to exacerbate supply chain disruptions.” That comes on top of Russia’s invasion of Ukraine and related events, which are “creating additional upward pressure on inflation and are likely to weigh on economic activity.”
Treasuries and stocks rallied following the decision, while the dollar extended its drop.
The increase in the FOMC’s target for the federal funds rate, to a range of 0.75% to 1%, follows a quarter-point hike in March that ended two years of near-zero rates to help cushion the US economy against the initial blow from Covid-19.
Policy makers, who widely signalled their intention to step up the pace of rate increases, are trying to curb the hottest inflation since the early 1980s, when then-chair Paul Volcker drastically raised rates and crushed the economy in the process. They hope that this time around that the combination of higher borrowing costs and a shrinking balance sheet will deliver a soft landing that avoids recession while tamping down inflation.
The personal consumption expenditures price index, the Fed’s preferred gauge, rose 6.6% in the year through March, more than triple the central bank’s goal – and a growing number of critics say the central bank waited too long to be able to stamp out inflation without causing a recession. Powell himself even told Congress in early March: “Hindsight says we should have moved earlier.”
Investors are increasingly betting the FOMC will opt for an even bigger rate increase, of three quarters of a percentage point, when it next meets in June – which would be the largest single hike since 1994. Several officials have in recent weeks expressed a desire to “expeditiously” bring the federal funds rate to around 2.5% by the end of the year, a level they deem roughly “neutral” for the US economy.
The statement repeated prior language that said, “with appropriate firming in the stance of monetary policy, the committee expects inflation to return to its 2% objective and the labour market to remain strong.” In addition, it reiterated that the Fed “anticipates that ongoing increases in the target range will be appropriate.”
Officials decided to begin shrinking the Fed’s $8.9tn balance sheet starting June 1, at a pace of $30bn in Treasuries and $17.5bn in mortgage-backed securities a month, stepping up over three months to $60bn and $35bn, respectively. The balance sheet had ballooned in size as the Fed aggressively bought securities to calm panic in financial markets and keep borrowing costs low as the pandemic spread.
The Fed said on Wednesday that “to ensure a smooth transition, the committee intends to slow and then stop the decline in the size of the balance sheet when reserve balances are somewhat above the level it judges to be consistent with ample reserves.”
Powell told Congress in early March the process would take about three years, implying some $3tn in reductions.
Market expectations for a series of interest-rate increases have already pushed up borrowing costs and begun to constrain demand in rate-sensitive industries such as the housing market. The yield on the benchmark 10-year Treasury note rose to 3% this week for the first time since 2018.
Powell and his colleagues have increasingly sought to connect high inflation to strength in the US labour market. The US unemployment rate in March was 3.6%, just above its pre-pandemic level. The Labor Department will publish figures for April on Friday.
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