The Federal Reserve on Wednesday raised its benchmark interest rate by a quarter percentage point to a range of 4.75% to 5%, the fourth increase this year, as it seeks to rein in inflation that has been running above its 2% target for months. The Fed also lifted its outlook for economic growth next year, projecting a 4.8% expansion, up from 4.5% in June.
The Fed’s statement said that the economy has made “substantial further progress” toward its goals of maximum employment and price stability, and that the risks to the outlook are “broadly balanced”. The Fed also said that it expects to begin reducing its $120 billion monthly bond purchases “soon”, which would mark a shift from its ultra-easy monetary policy stance since the onset of the pandemic.
However, the Fed’s projections also showed that most policymakers expect three more rate hikes in 2023, bringing the federal funds rate to 5.1% by the end of next year. This suggests that the Fed is prepared to tighten monetary policy more aggressively than previously anticipated, as it tries to prevent inflation from becoming entrenched and destabilizing the economy.
Markets react to Fed’s hawkish tone
The Fed’s hawkish tone rattled the financial markets, as investors worried that higher interest rates could dampen economic growth and corporate profits. The yield on the 10-year Treasury note, which reflects expectations of future inflation and growth, spiked to a 16-year high of more than 4.5% on Thursday, before retreating to 4.3% on Friday. The higher yields also weighed on the stock market, as they make bonds more attractive relative to equities and increase borrowing costs for businesses and consumers.
The S&P 500 index, which tracks the performance of the largest U.S. companies, fell 1.6% on Friday, ending the week with a 2.8% loss, its worst since March. The Dow Jones Industrial Average and the Nasdaq Composite also posted steep declines, as sectors such as technology, consumer discretionary and energy suffered the most. The volatility index, or VIX, which measures investors’ fear level, surged to its highest level since May.
The U.S. dollar, on the other hand, strengthened against other major currencies, as higher interest rates make it more attractive for foreign investors. The dollar index, which measures the greenback against a basket of six peers, rose 0.6% on Friday, reaching its highest level since November 2020.
Fed officials warn of inflation risks
The Fed’s decision to raise rates and signal more hikes ahead was driven by its concern about inflation, which has been persistently high amid supply chain disruptions, labor shortages and strong consumer demand. The Fed’s preferred measure of inflation, the core personal consumption expenditures (PCE) index, rose 3.6% in July from a year ago, well above the Fed’s 2% target.
While the Fed has maintained that inflation is largely transitory and will ease as the pandemic-related factors fade, some Fed officials have expressed doubts about this view and warned that further action may be needed to ensure price stability.
On Friday, three Fed officials – St. Louis Fed President James Bullard, Dallas Fed President Robert Kaplan and Philadelphia Fed President Patrick Harker – spoke at separate events and indicated that they were uncertain that inflation will moderate soon and that they favored a faster pace of rate hikes than the median forecast.
Bullard said that he expects inflation to remain elevated in 2023 and that he projects four rate hikes next year. He also said that he would like to see the Fed start tapering its bond purchases in November and end them by March.
Kaplan said that he is worried that inflation expectations are rising and that he advocates three rate hikes in 2023. He also said that he supports tapering bond purchases starting in October or November and ending by mid-2023.
Harker said that he is concerned about inflation becoming more persistent and that he prefers two or three rate hikes in 2023. He also said that he agrees with tapering bond purchases soon and ending them by mid-2023.
Global implications of Fed’s policy shift
The Fed’s policy shift has implications for the global economy and financial markets, as it could affect capital flows, exchange rates and growth prospects in other countries. The Fed’s move could also put pressure on other central banks to follow suit and tighten their own monetary policies, or risk losing competitiveness and facing currency appreciation.
Some central banks have already started to raise interest rates or signal their intention to do so in response to rising inflation and growth pressures in their own economies. For example, the Bank of England hinted at a possible rate hike as soon as November, while the Bank of Canada said it could start raising rates in the second half of 2023.
Other central banks, however, have maintained their accommodative stance or even eased their policies further, citing the uncertainty and risks posed by the pandemic and its variants. For example, the European Central Bank said it will keep its interest rates at record lows and increase its bond purchases slightly in the fourth quarter, while the Bank of Japan kept its policy unchanged and said it will continue to support the economy with massive stimulus.
The divergence in monetary policies among major central banks could lead to increased volatility and imbalances in the global financial system, as investors adjust their portfolios and expectations. The Fed’s policy shift could also have spillover effects on emerging markets, which are more vulnerable to capital outflows, currency fluctuations and higher borrowing costs.
