Federal Reserve Uses Entire Arsenal on Inflation

Fed Raises Benchmark Interest Rate by Half Percentage Point

Figurative custom illustration of the Federal Reserve walking a tightrope.
Photo:

The Balance / Alice Morgan

The Federal Reserve wielded both major tools for fighting inflation Wednesday, raising its benchmark interest rate by a highly unusual (but widely expected) half percentage point and announcing plans to cut back holdings of the assets it bought to support the economy during the pandemic. 

Key Takeaways

  • The Federal Reserve ramped up its fight against inflation, hiking its interest rate by 0.5 percentage point—double its typical increase—as most experts had expected.
  • The Fed is raising the rate to raise borrowing costs and in turn reduce spending and demand for goods and services. That should help cool inflation but at a painful cost to many households and businesses.
  • The central bank said it would continue to raise the rate until inflation is brought to heel.

Fed officials raised the benchmark fed funds rate to a target range of 0.75%-1% from 0.25%-0.50%, double the typical increase and the first one that size since 2000. The Fed also detailed plans to reduce its holdings of mortgage-backed securities and other assets bought earlier in the pandemic in order to help keep financial markets running and support lending to households and businesses. 

The moves show just how serious the Fed’s Federal Open Market Committee is taking the recent spike in inflation, which officials readily acknowledge sneaked up on them and has only been made worse by the war in Ukraine. Taking money out of the economy and raising borrowing costs should discourage spending and reduce demand to cool the nation’s 8.5% inflation rate, the highest in 40 years. But it’s a difficult balancing act—to slow the economy enough to restrain inflation, but not so much that all economic growth is squashed and the country goes into a recession

“Inflation is much too high, and we understand the hardship it is causing. And we're moving expeditiously to bring it back down,” Fed Chair Jerome Powell said to start a press conference following the committee’s regular two-day meeting.

The fed funds rate had been nearly zero since the start of the pandemic, a support mechanism for an economy with severe and sudden job loss. But in March of this year, the central bank raised the rate by a quarter percentage point and said many more increases would follow.

The median projection of Fed officials at the time showed they expected a fed funds rate as high as 2.8% by next year, but economists at Deutsche Bank estimated last week that the rate would have to go as high as 6% to get the job done. The benchmark hasn't been that high in over 20 years and would very likely cause a serious recession, notably increasing the unemployment rate, the economists said. 

Note

The fed funds rate heavily influences interest rates throughout the economy, including on credit cards and car loans, but it’s not the rate you get on those loans. Banks typically charge a set amount above their so-called prime rate, and the prime rate moves in tandem with the fed funds rate, but is typically about 3 percentage points higher. 

Powell acknowledged Wednesday that the Fed’s actions could have painful consequences, since higher borrowing costs mean less investment by businesses and less spending by consumers. 

“What it means for consumers is higher financing costs, which is a downer,” said David Beckworth, senior research fellow at George Mason University’s Mercatus Center. “The upshot, though, for consumers, will be that eventually inflation should decline. It's a double-edged sword for consumers—higher financing costs in the short term, but in the long run, lower inflation.”

Powell said he believed the economy could achieve a “soft or soft-ish landing” and avoid recession, but the Fed is prepared to do what it takes to bring inflation to heel, even if that means an economic downturn. More half-point hikes are “on the table” for the Federal Open Market Committee’s next meeting in June and in later months, but larger rate hikes are not currently being considered, he said at the press conference.

Stocks got a boost from his encouraging words, with the Dow Jones Industrial Average, the S&P 500 Index, and the Nasdaq Composite all ending the day up more than 2%.

While the latest rate increase was necessary, it’s not likely to be enough on its own to tame inflation, said Oren Klachkin, lead economist at Oxford Economics.

The Fed said it would start its asset reductions in June and gradually ramp up the pace until it was shrinking its balance sheet by $95 billion worth of securities every month—a widely expected move.

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Additional reporting by
Terry Lane
Terry Lane
Terry Lane has spent more than 20 years in journalism and public affairs and is well-versed in the telecommunications and energy sectors. Just as comfortable in the halls of Congress as in a local newsroom, he’s been press secretary for the House Energy & Commerce Committee and the publisher of a community newspaper.
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Sources
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.
  1. Federal Reserve. “Federal Reserve Issues FOMC Statement.”

  2. Federal Reserve. “Plans for Reducing the Size of the Federal Reserve's Balance Sheet.”

  3. Federal Reserve. “FOMC Press Conference May 4, 2022.”

  4. Federal Reserve. “March 16, 2022: FOMC Projections Materials, Accessible Version.”

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