President Jerome Powell said on Wednesday he supports a traditional quarter-point increase in the Federal Reserve’s benchmark short-term interest rate when the Fed meets later this month, rather than a larger increase suggested by some policymakers.
But Powell has opened the door for a larger increase if inflation, which is at its highest level in four decades, does not fall significantly this year, as the Fed expects.
“I am inclined to propose” a quarter-point rate hike to combat the accelerating inflation that has swept the economy in recent months, Powell told the House Financial Services Committee in the first two days of semi-annual testimony to Congress.
Most other Fed officials in recent weeks have supported a similar modest rise, while some have said they support a half-point increase. Or at least open to such an increase. Typically, higher Federal Reserve rates, in turn, raise borrowing costs for consumers and businesses, including home and auto loans and credit cards.
“We have an expectation that inflation will peak and start to decline this year,” Powell said. But he added, “to the extent that inflation comes to a higher level … we will be ready to move in more aggressively” by raising interest rates by more than a quarter point later this year.
The stock market rose in response to Powell’s support for the smaller increase. The S&P 500 jumped 1.7% in mid-day trading.
The head of the Federal Reserve warned that the economic consequences of the invasion of Russia Ukraine, and the resulting sanctions by the United States and Europe, are “highly uncertain” and said it was “too early to say” how they might affect the Fed’s policies.
Powell said that before the Russian invasion, the Fed planned to implement a “series” of rate increases this year, likely at each of the Fed’s seven remaining meetings. For now, the Fed will “proceed cautiously along the lines of that plan”.
Economists expect the Fed to implement five to seven quarter-point increases this year. This month’s increase will be the first since 2018. It will be the start of a delicate challenge for the Fed: It wants rates to rise enough to bring down inflation, which is now at its highest level in four decades, but not as fast as growth and employment are stifling. Powell is betting that with unemployment at 4% and consumer spending strong, the economy can afford modestly higher borrowing costs.
The Fed rate is now pegged close to zero, which it has been since the pandemic hit in March 2020 and the Fed has responded by cutting interest rates to help support the economy.
Powell acknowledged that increases in consumer prices have jumped well above the Fed’s 2% target – inflation was 7.5% in January from a year earlier. And that the high prices lasted longer than expected. He also pledged to use the Fed’s tools to bring inflation back to the target level.
“We understand that high inflation imposes significant hardship, especially on those least able to meet the high costs of necessities such as food, housing, and transportation,” the Fed chair said.
However, he added, the central bank expects inflation to decline gradually this year as interlocking supply chains unravel and consumers pull back a bit from spending.
Most economists agree that inflation is likely to fall below its current level but will nonetheless remain high. The price hike is spreading beyond the items disrupted by the pandemic — cars, electronics, furniture and other household goods — into broader spending categories, especially rental costs..
Goldman Sachs raised its inflation forecast and now expects that rates, as per the Fed’s preferred procedure, will continue to rise at a relatively high annual rate of 3.7% by the end of the year. This is well above the Fed’s latest forecast, released in December, of 2.7%. When central bank policy makers meet in two weeks’ time, they will update this forecast.
Powell said the Fed will also start cutting its massive $9 trillion balance sheet, which more than doubled during the pandemic when the Fed bought trillions of dollars in bonds to try to lower long-term interest rates. He said central bank policy makers are likely to agree on a plan for how to reduce its bond holdings when it meets in two weeks, but declined to say when the plan would be implemented. The Fed’s shrinking balance sheet has the effect of increasing long-term borrowing costs.
In public statements, central bank officials have been discussing Whether to raise interest rates this month by half a percentage point – a strong move – although most backed the traditional quarter-point increase. The Russian invasion of Ukraine made a half-point increase less likely.
The invasion of Ukraine sent oil prices up about 18% to nearly $110 a barrel, which would make gas more expensive. Some economists have forecast gas prices will soon average $4 a gallon, up from the $3.66 national average on Wednesday.
More expensive energy will send inflation higher than it could have in the coming months, strengthening the case for the Fed’s rate hike. But more expensive gas also deprives consumers of money to spend on other things. This, in turn, is likely to reduce consumer spending and potentially weaken the economy – a scenario that usually discourages the Fed from raising interest rates.
Other than its impact on inflation, the war may have only a limited impact on the US economy, analysts say, as long as it does not escalate significantly. Only about 0.5% of US trade is with Russia.
Powell warned that the war could lead to shortages of such commodities as neon and palladium, which are used in semiconductor production. A shortage of computer chips in the past year has slowed production of cars and electronics and contributed to rising inflation.
But the Fed chair also indicated that the overall impact of the war on the US economy may be limited as long as the conflict does not escalate significantly.
“Our financial institutions and our economy do not have significant interactions with the Russian economy,” he said. “It’s gotten smaller and smaller in recent years.”