Fed pencils in earlier interest rate increase

Fed officials signal a rise in interest rates by late 2023, sooner than earlier forecast, as the US economy recovers and inflation heats up.

Jerome Powell says the Fed expects the current high inflation readings to start to abate. Picture: Bloomberg

Federal Reserve officials signalled they expect to raise interest rates by late 2023, sooner than they anticipated in March, as the economy recovers rapidly from the effects of the pandemic and inflation heats up.

Their median projection showed they anticipate lifting their benchmark rate to 0.6 per cent from near zero by the end of 2023. In March they had expected to hold it steady through that year.

Fed officials also discussed an eventual reduction, or tapering, of the central bank’s bond-buying program, chairman Jerome Powell said at a press conference after the central bank’s two-day policy meeting. The timing of such a move remains uncertain, he added.

Prompting the policy shift is a much stronger economic rebound and hotter inflation than the Fed anticipated just a few months ago.

“Progress on vaccinations has reduced the spread of Covid-19 in the United States,” the Fed said in a statement following the meeting. “Amid this progress and strong policy support, indicators of economic activity and employment have strengthened.”

In updated projections, 13 of 18 officials indicated they expect to lift short-term rates by the end of 2023, up from seven who expected that outcome in March. In March, most of them anticipated holding rates steady through 2023.

The Fed has its benchmark federal-funds rate steady since March 2020, when the effects of the pandemic caused the sharpest economic contraction in generations. The central bank also has been purchasing at least $US120 billion a month of Treasury and mortgage bonds since June 2020 to hold down longer-term borrowing costs, providing further support to the recovery.

The Fed reiterated that it expects to continue bond purchases until “substantial further progress” has been made in the recovery, counting from December 2020.

Fed officials want the economy to get closer to their goals of “maximum employment” and sustained, 2 per cent inflation before reducing the bond purchases. They have said they want to fully achieve those objectives before they raise interest rates.

“Honestly the main message I would take away from the [forecasts] is that participants—many participants—are more comfortable that the economic conditions in the committee’s forward guidance could be met somewhat sooner than anticipated,” Mr Powell said. “That would be a welcome development.”

He said meeting the standard for reducing bond purchases remains “a ways away.” But he added that the economy is making progress toward the Fed’s goals and that policy makers will be assessing the appropriate time to begin scaling back the purchases at coming meetings.

“You can think about this meeting that we had as the ‘talking about talking about tapering,’ if you like,” Mr Powell said.

Since officials’ previous meeting, in April, the labour market’s progress has been somewhat slower than they had anticipated. Employers added 837,000 jobs in April and May, leaving total employment 7.6 million jobs shy of pre-pandemic levels.

Policy makers have become less confident in recent weeks the economy can recover all the jobs lost amid the pandemic without spurring inflation. Some 2.6 million people retired between February 2020 and April, according to estimates from the Dallas Fed. A steadily ageing US population suggests limited scope for reversing that trend, some economists say.

“We’ve seen a significant number of people retire,” Mr Powell said. “So we don’t actually know exactly what labour-force participation will be as we go forward. But I would tend to look at it and think that it can return to high levels, although it may take some time to do that.”

Jerome Powell said the Fed plans to give markets plenty of advance notice before it begins withdrawing the easy-money policies. Picture: AFP

In contrast, inflation has been higher than expected. The Labor Department’s consumer-price index rose 5 per cent in May from a year earlier.

That inflation rate, the highest since 2008, makes the Fed uncomfortable, even if officials reiterated Wednesday that they think it mostly reflects temporary factors that should fade later this year. They worry that if inflation exceeds 2 per cent too much or for too long, it might lead businesses and consumers to anticipate more inflation in the future, which can become self-fulfilling. Evidence of rising inflation expectations would likely require the Fed to tighten policy sooner or more aggressively than planned to re-anchor those expectations around 2 per cent.

“Our expectation is that these high inflation readings that we’re seeing now will start to abate,” Mr Powell said. He noted that the biggest drivers of the price increases, such as for used-cars, have been related to the pandemic’s effects. But he also pointed to the risk of the inflation spurt causing consumers and businesses to expect higher inflation, thereby causing it to rise, which would lead the Fed to tighten policy.

“We wouldn’t hesitate to use our tools to address that,” Mr Powell said. “Price stability is half of our mandate.”

Policy makers now expect their preferred measure of inflation to rise 3.4 per cent in the fourth quarter of 2021 from a year earlier, up from a March forecast of 2.4 per cent. They revised up their projection for fourth-quarter-to-fourth-quarter economic growth to 7 per cent from 6.5 per cent.

Officials left their forecast for unemployment in the fourth quarter of this year at 4.5 per cent, unchanged from their March projection. The jobless rate stood at 5.8 per cent in May.

Mr Powell reiterated that the Fed plans to give markets plenty of advance notice before it begins withdrawing the easy-money policies it put in place last year amid the pandemic.

Among his objectives is to avoid triggering the sort of market turmoil, or “taper tantrum,” that ensued when the Fed announced plans to scale back a similar bond-buying program in 2013.

He said concern about such an event won’t deter the central bank from moving forward.

“We will do what we can to avoid a market reaction, but ultimately, when we achieve our macroeconomic goal, we will taper, as appropriate,” Mr. Powell said.

Wall Street Journal