Fed Is Finally Moving on Inflation, but at What Cost?

Interest rate hikes could roil the financial markets and economy, experts say

Fed Chair Jerome Powell pursing his lips

Pool / Getty Images

The Federal Reserve, determined to rein in inflation, has become dramatically more aggressive in its stance on interest rate hikes and other tools it has to fight surging prices. But getting things right won’t be easy.

Key Takeaways

  • The Fed has quickly pivoted to make stopping high inflation its top priority.
  • Some analysts fear the central bank is too late and will do too little, while others say panic will force it to be overly aggressive.
  • Neither scenario will be “sweet and gentle” for financial markets or the economy.

After virtually ignoring the rapid increase in consumer prices over the last year, moving too far too fast now could cause asset prices, particularly stocks and real estate, to collapse, experts say, and could even tip the economy into recession. On the other hand, not doing enough could leave inflation running uncomfortably hot and continuing to hit consumers in the pocketbook.

Members of the Federal Open Market Committee, the policy-making arm of the central bank, have been far more hawkish, or aggressive, in the last few weeks than they were during most of last year. That means they are more willing to take steps to bring down inflation, including raising the benchmark federal funds rate, currently near zero, several times in 2022. Inflation was running at 7% in the 12 months through December, the highest level since 1982.

Federal Reserve Chair Jerome Powell said on Wednesday that a rate hike could come as soon as March. Powell made the comment in a press conference following the Fed’s latest two-day policy meeting. 

Most economists welcome the central bank’s pivot. But some analysts say that now, after many months of virtually ignoring the warning signs that inflation was getting out of control, the Fed is too late and the “landing” will be anything but soft. 

Jamie Dimon, CEO of JPMorgan Chase, put things this way in an earnings call earlier this month: “This whole notion that somehow it’s going to be sweet and gentle and no one is ever going to be surprised, I think it’s a mistake.” Dimon said he expects more than four interest rate hikes this year, and perhaps as many as six or seven.

“Blunders by the Fed in 2021 come with a cost—higher rates, increased volatility, and sharply lower equity prices in 2022,” said Joe Carson, former chief economist and director of global economic research for Alliance Bernstein, in his blog. 

The stock market has already started hiccuping. Volatility has picked up this year, and as of Thursday, the S&P 500 had lost 9.8% from its record high on Jan. 3 and the Dow was off 7.2% from its high Jan. 4. The tech-heavy and rate-sensitive Nasdaq was down more than 15.6% from its all-time high Nov. 19, in correction territory and approaching a bear market. Meanwhile the 10-year Treasury yield, the basis for rates on loans like mortgages, has risen to its highest level since the end of 2019. 

Some observers even believe the U.S. economy is headed for a recession. In a Deutsche Bank global survey of more than 500 market professionals including money managers, traders, and analysts around mid-January, nearly 75% of respondents predicted a recession by 2024, significantly higher than the percentage who said that the month before. Thirty-six percent of respondents said the recession would come in 2023 and the same percentage said it would be in 2024.

Seemingly Unworried

At the beginning of the pandemic in 2020, the Fed stepped in to prevent massive damage to the economy by slashing its benchmark short-term interest rate to near zero. That was meant to encourage spending and investing and keep the financial system flush with cash. The benchmark rate indirectly influences interest rates for all kinds of things, including credit cards, car loans, and mortgages.

To further support the economy, the central bank also began a temporary bond-buying program, purchasing Treasuries and asset-backed securities on the open market to provide liquidity to the banking system and essentially keep credit flowing to businesses that needed it during the pandemic.

For much of 2021, Powell and other FOMC members seemed unworried about the quickly rising price of goods and services, saying they were okay with inflation running above their 2% target rate for a time as long as it evened out over the long run.  Powell repeatedly said inflation was “transitory,” or temporary, and that rising prices in 2021 were the result of pandemic-driven disruptions to the supply chain. Inflation, the thinking went, would settle down sooner rather than later.

When Doves Cry

Only in November, with prices rising and the economy back on a steady growth track, did the Fed start to change its tune, cutting back on support for the economy by reducing the amount of its bond buying each month.

But December really marked the turning point. That’s when the Fed finally acknowledged that inflation was higher than expected and was spreading more broadly. The central bank doubled the pace of its asset-buying wind-down, saying it would end the program in March, earlier than originally expected. And at the December policy meeting, every one of the 18 FOMC members (twice as many as in September) said they expected an increase in the fed funds rate in 2022, and 10 members (up from zero in September) predicted three rate hikes.

“The risk of higher inflation becoming entrenched has increased,” Powell said at a news conference following the meeting.

Perhaps the most notable turnaround has come from San Francisco Fed President Mary Daly, usually seen as dovish, or softer on inflation-fighting. “I definitely see rate increases coming as early as March,” she said in a PBS Newshour interview on Jan. 12. “This inflation we're seeing … that's not price stability. And I think every American knows it and feels it. But, also, the Fed knows it and feels it.”

Damned If You Do, Damned If You Don’t

To catch up to inflation, it may be necessary to raise the benchmark rate aggressively, some analysts say. Bill Nelson, executive vice president and chief economist at BPI, says a 50-basis-point rate increase in March will help the Fed regain credibility and set expectations that it means business. Typically, the central bank raises the rate 25 basis points at a time. The last time the Fed raised its benchmark rate by half a point was in May 2000.

Carson also thinks the Fed may need to pull the trigger hard. He says the Fed’s long-run median projection for the fed funds rate–2.5% by 2025–isn’t enough.

But others fear an overly aggressive Fed could damage the economy.

“I think we’re barreling towards a policy error,” Ryan Sweet, economist at Moody’s Analytics, said. “This cycle feels a little more fast and furious, and when that happens, things can go wrong.”

Adding to the concern is the possibility that the Fed will take yet another step—beyond raising its benchmark rate and ending its bond-buying program—to combat inflation: reducing its balance sheet. When the Fed buys bonds on the open market, as it has been doing, those bonds are held until they mature. By cashing out maturing assets and not replacing them—in other words, by “running off” the balance sheet—the Fed drains money from the system and allows the market to absorb the additional supply it isn’t buying. It’s another way of tightening the money supply and attempting to bring down inflation.

The runoff of the balance sheet could be coming sooner rather than later. The Fed said on Wednesday it expects this process would begin soon after it has started increasing the target range for the federal funds rate (which could be in March, as indicated by Powell).

The last time the Fed began reducing its balance sheet, in 2017, it had waited nearly two years after its first interest rate increase. If the Fed does both things at the same time now, that could have unpredictable effects.

However it goes, “This is the first time the Fed has chased” inflation since the 1980s, instead of trying to preempt it, said Diane Swonk, chief economist at Grant Thornton, in a commentary. “Brace yourselves.”

Have a question, comment, or story to share? You can reach Medora at medoralee@thebalance.com.

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The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
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  2. Federal Reserve Bank of St. Louis. “Market Yield on U.S. Treasury Securities at 10-Year Constant Maturity.”

  3. Federal Reserve. “Federal Reserve Issues FOMC Statement.”

  4. Federal Reserve. “Summary of Economic Projections - September 22, 2021.”

  5. Federal Reserve. “Transcript of Chair Powell's Press Conference -- December 15, 2021.”

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  7. Federal Reserve Bank of St. Louis. “What Is Quantitative Tightening?

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