Fed signals March rate rise as it fights rampant inflation

The Federal Reserve signalled its intention to raise interest rates in March, the first increase since 2018, underscoring the US central bank's abrupt pivot to fighting rampant inflation as opposed to shielding the US economy from the pandemic.

The Federal Open Market Committee (FOMC) on Wednesday noted the strong economic recovery and “solid” job gains in recent months, laying the groundwork to quickly tighten monetary policy in an attempt to damp demand.

“With inflation well above 2 per cent and a strong labour market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate,” the policymakers said in a statement at the end of a two-day meeting.

The central bank had pledged to keep its main policy rate at rock-bottom levels – where it has sat for two years – until achieving maximum employment and inflation that averages 2 per cent over time.

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Inflation goal

The inflation goal was fulfilled last year, and the Fed on Wednesday noted that the unemployment rate, which now hovers at just below 4 per cent, had declined “substantially”.

The Fed also on Wednesday sped up plans to wind down its bond-buying programme so that the purchases end in early March, a few weeks earlier than previously planned.

The Fed’s move towards tighter monetary policy comes during a period of extreme volatility for financial markets with US stocks whipsawing in recent days as investors rush to position themselves for a more hawkish stance from the central bank.

In the weeks leading up to the January meeting, several Fed officials signalled their support for “lift-off” in March, citing underlying strength in the US labour market and inflation that is running at its fastest pace in roughly four decades.

The FOMC and other regional branch presidents last month pencilled in three quarter-point increases in 2022, with three more in 2023 and another two in 2024. At the time, they forecast core inflation to moderate to 2.7 per cent by the end of the year from the current level of 4.7 per cent, and the unemployment rate to fall to 3.5 per cent.

However, in recent weeks many Fed officials and Wall Street economists have said that a more aggressive rate rising cycle may be warranted with four increases this year.

If inflation does not ease the speed at which the Fed scales back its support and moves its main policy rate closer to 2.5 per cent may accelerate. That could result in interest rate increases in March and at each of the subsequent six meetings this year, economists say, as the Fed takes bolder steps to dampen red-hot demand.

Substantive discussions

Debate is also under way about how the Fed will shrink its roughly $9 trillion (€8 trillion) balance sheet, after policymakers held their first substantive discussions on the central bank’s holdings last month.

The Fed was expected to have held further deliberations at this week’s meeting, but no decision has been made about how rapid the reduction will be or when it may begin. Officials appear to agree the “run off” should proceed more quickly than the that was made to pare back holdings it in 2017, when the balance sheet hovered at about $3.7 trillion (€3.3 trillion).

The 2017 episode ended in acute financial market stress – with short-term borrowing costs spiking as it became evident that too much cash had been drained from the financial system.

Economists broadly expect the next run-off to begin in July, with some suggesting an earlier start.

– Copyright The Financial Times Limited 2022