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The Fed increases rates by 0.5% — its biggest rate hike since 2000

May 5, 2022 3 min read
Jim Baird Wealth Management
In response to high inflation and exceptionally tight labor markets, the Fed announced its decision to increase interest rates and reduce its balance sheet.

Capitol building with flag in front

To nobody’s surprise, the Fed announced today its decision to raise its policy rate by 0.5% effective immediately, lifting the benchmark rate to a range of 0.75% to 1.0%. The Fed’s announcement delivered what Federal Open Market Committee members had strongly indicated in recent weeks. In that regard, they’ve been effective in creating expectations and then delivering on those self-defined goals.

Additionally, the Fed announced that it would also begin to trim its balance sheet by reducing its Treasury holdings by about $30 billion/month and mortgage-backed securities by $17.5 billion/month.

The move comes as the Fed has been under increasing pressure to act more aggressively, as already high inflation edged even higher in recent months and labor market conditions remained tight. There’s been a growing sense that the Fed had fallen behind the curve — an assessment that Fed Chair Powell acknowledged during his March press conference.

The Russian invasion of Ukraine likely disrupted the Fed’s March plans, just as the emergence of the COVID-19 Delta variant last fall created enough doubt about the outlook at the time to give them reason for pause. The compromise was a modest quarter-point hike in March — better than continuing to hold the line, but less than was otherwise warranted given the Fed’s inflation target and the scope of inflation and jobs data at the time.

The 0.5% increase is the first since 2000, signaling the additional urgency to move beyond measured quarter-point moves to address inflation concerns.

Whether or not the Fed will be able to thread the needle remains to be seen. The challenge for policymakers lies in part in the fact that the sustained upward pressure on prices is a product of not only strong demand but constricted supply.

On the labor side of the economy, many workers who left the jobs market in 2020 have yet to return, shrinking the pool of available workers even as job openings are at record highs. Meanwhile, global supply chains remain kinked and production capacity remains curtailed. China’s recent aggressive measures to contain COVID-19 have certainly played a role, as has the disruptive effect of the conflict in Ukraine and resulting sanctions against Russia on the flow of commodities from the region. These limitations would have produced a lift under prices even in the absence of robust demand. The convergence of strong goods demand with constrained supply explains an inflation environment unseen in several decades.

The case for aggressive action is clear. The Fed must take tangible steps to combat inflation and cool the economy, but monetary tightening is targeted at demand-driven inflation. The Fed can’t fix supply-side challenges with higher interest rates. Fed tightening doesn’t re-open Chinese factories, increase grain shipments from Ukraine, re-position container ships to where they‘re needed, or hire truck drivers to move goods.

The ideal scenario for the Fed is that its tightening measures are successful in cooling demand without killing it, with production and logistical impediments to the supply side of the economy continuing to resolve themselves in the coming months.

The risk is that the Fed is successful in cooling demand, but production and supply chain challenges drag on. A hard landing for the U.S. economy isn’t out of the question, and the path ahead for the Fed will not be an easy one. Policymakers must continue to send an unambiguous message to the markets that they‘re serious about fighting inflation to keep long-term inflation expectations anchored, while not being so aggressive that they bring a premature end to the current expansion.

The bottom line: There were no real surprises in today’s Fed announcement. We should expect the Fed to be highly data dependent in the coming months but maintain a more aggressive bias in the execution of monetary policy.

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