Federal reserve hikes interest rates to battle inflation
Consumers all across the country feel burned by high prices everywhere from the grocery store to the gas station. But will that frustration — and their increasingly overstretched budgets — cause the economic recovery to go up in smoke?
The Fed, our chief inflation fighter right now, is dealing with a blaze that won’t be easily put out by a few rate hikes. On Wednesday, the Fed’s battle led to a dramatic, sudden 75-basis point rate hike instead of the smaller, long-expected increase of a half of a percentage point.
“Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures,” according to the Fed’s statement released at 2 p.m. Wednesday.
The Fed referred to economic hardship relating to the invasion of the Ukraine by Russia. In addition, the Fed noted: “COVID-related lockdowns in China are likely to exacerbate supply chain disruptions.”
The Fed usually moves in dribs and drabs, a quarter point here, a quarter point there. The last time we saw the Fed engineer a hawkish, 75-basis-point hike was when then Federal Reserve Chairman Alan Greenspan took action in late 1994.
The target range for the federal funds rate — the rate that determines borrowing between banks — had been 0.75% to 1%. This rate directly influences the interest rate you pay on many consumer loans, too, including credit cards.
Now, Wednesday’s 75-basis-point hike puts the federal funds rate at a new target range of 1.5% to 1.75%.
The average 30-year mortgage rate shot up above 6% this week in anticipation of a steeper Fed rate.
Mark Zandi, chief economist for Moody’s said, the 75-basis point hike is designed to send a strong signal that the Fed will do whatever it takes to get inflation back down.
By moving aggressively, he said, the Fed is managing inflation expectations and making it more likely it can get actual inflation down. But there are risks.
“In my humble opinion,” Zandi told the Free Press, “I don’t think they need to raise rates by 75 basis points to keep inflation expectations down.”
By raising rates so quickly, he said, “they raise the odds of pushing the economy into recession.”
Federal Reserve Chairman Jerome Powell said Wednesday that he did not expect a hike this large to be common in the future. But he noted that a rate hike of 50 basis points or 75 basis points seems most likely at the next Fed meeting in July.
By this point, Powell said, the expectation was that inflation would be flattening by now. Instead, he said, inflation has surprised the Fed on the upside and risks of higher inflation remain.
“We were expecting progress, and we didn’t get that. We got sort of the opposite,” Powell said.
How we got here
The theory was that the economy could withstand a temporary bout of inflation to avoid massive unemployment during the pandemic. Early on, the theory worked.
The economic emergency response to the COVID-19 crisis got the country out of a short but deep recession in 2020 by throwing out trillions of dollars in stimulus spending — accompanied by a Fed policy for keeping interest rates extraordinarily low to support borrowers.
Vaccines rolled out in late 2020 and early 2021, the jobless rate fell from shocking double digits, the economy saw a robust rebound but the spending kept going and the Fed kept short-term rates at nearly 0% for two years. We only saw the first quarter-point interest rate hike in March; and then a half point hike in May.
For decades, the Fed has nudged rates higher before prices got out of control. Now, though, the Fed is behind the curve as it fights accelerating inflation.
Many people have long forgotten the financial mess the country faced in 2020. They’re now hyper-focused on how much more they’re paying for gas, groceries, rent and airplane tickets.
High demand and short supply on many goods have driven up prices on everything from bacon and eggs to new and used cars to home furniture and houses, too.
Inflation is far more stubborn than the Federal Reserve and many economists had forecast a year ago. The consumer price index has run hot at 6.8% and higher since last November for each month measuring the 12-month change.
June’s inflation numbers — which won’t come out until July 13 — could top May’s 8.6% rate. May’s inflation figure was the highest level since December 1981 and the worst in the last inflation surge.
Powell said Wednesday it was unusual for the Fed to shift direction so close to a meeting. But new data released last week — including May’s CPI figure and inflation expectations as expressed in preliminary data from the University of Michigan Surveys of Consumers — factored into the Fed’s move to a 75-basis-point hike, instead of a 50-basis-point hike, he said.
Given that inflation has roared ahead for months, the Fed’s playbook will include more rate hikes ahead.
Bill Adams, chief economist for Comerica Bank, told the Free Press in a phone interview that he’s expecting a similar sized rate hike again at its next meeting July 26 and July 27.
After that, Adams anticipates that the Fed will raise rates by a quarter of a percentage point at each of its meetings in September, November and December.
If — and this a big unknown — economic growth or inflation end up slowing down more than expected, Adams said, there’s a possibility that the Fed could pause a bit in September.
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The Fed has to watch the data and try to avoid slamming the brakes entirely on economic growth.
While some analysts say it will be hard to avoid a recession here, Adams puts the odds of a recession in 2022 at one in 10. His odds go up to one in four for 2023.
The odds of a recession have increased, but he maintains it is “still more likely that we see the U.S. economy muddle through.”
When will inflation actually cool off?
Gas prices at $5 a gallon and up and a meltdown in the stock market aren’t reassuring — and only put consumers more on edge. Some wonder if the economy will face an economic slowdown and escalating prices at the same time.
The war in Ukraine and economic sanctions on Russian oil complicate the inflation outlook in the United States.
“As long as the energy supply is disrupted by that war, prices of basic necessities are going to stay high,” Adams said.
He notes that high prices for gas and utilities are a big headwind.
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Gas prices rose 48.7% year over year through May, according to the Bureau of Labor Statistics.
Gas prices of $5 a gallon and higher are likely to be with us for some time, according to Treasury Secretary Janet Yellen and various economists.
Right now, many consumers can cover price hikes by tapping into a larger than usual savings cushion from some wage gains and a flood of pandemic-related stimulus money. That can help shore up growth somewhat.
“Americans are still buying. And incomes are rising but gas prices are rising much faster,” Adams said.
Things are far worse for those who don’t have much savings or those who didn’t see their pay rise at all in the past year. They’re having to make serious cutbacks and experiencing a lower standard of living.
“A lot of Americans who thought they were ready to retire in 2020 or 2021 are now having to reconsider that decision,” Adams said, “because of the increase of the cost of living.”
Rate hikes will cool down borrowing
By boosting interest rates, the Fed is blocking many consumers from borrowing big time.
Some who had planned to take on a mortgage or a car loan also need to reconsider what they’re willing to spend, as rates are expected to keep climbing in 2022.
The average five-year new car loan rate is currently 4.53%, according to Bankrate.com. But it is expected to hit 5.75% by early 2023.
Credit card borrowers will see immediate pain, as cards have variable rates that go up as the Fed drives short term interest rates higher.
If you locked in ultra low promotional rates on credit cards for several months, watch out when those introductory periods end. “The rate your card will jump to at the end of the promotional period is rising every time the Fed boosts rates,” warned Greg McBride, chief financial analyst for Bankrate.com.
The average credit card rate is currently 16.68% and could hit 17.9% by early 2023 but that average also reflects new attractive offers to some consumers, McBride said.
Homeowners who have a home equity line of credit will see their interest rates go up directly with every single Fed interest rate hike, too.
Mortgage rates surged above 6% Monday when anticipation of the Fed rate hike Wednesday led to a major sell off in the bond market.
The average 30-year rate had been 5.23% for the week ending June 9 — up from an average 2.96% a year ago, according to Freddie Mac’s latest data.
Zandi said mortgage rates could approach 7% in coming weeks before pulling back in 2023. Long run, he said, the average 30-year mortgage rates should be closer to 5.5%.
We’re already starting to see price declines on appliances, furniture, home decorating items and other household goods, according to the latest CPI data for the past 12 months through May.
“It does seem like we’re starting to see the fever break in housing,” Adams said.
Some retailers, including Target and Walmart, have reported that they will need to offer significant discounts on electronics, furniture and other items after a shift in consumer buying patterns.
“Americans splurged on consumer goods in 2020 and 2021 when they were stuck at home and afraid to go on vacation and go to restaurants, concerned about the pandemic,” Adams said.
“Now that lifestyles are getting back to normal, people are spending more on services and more on recreation and they’re spending less on consumer goods,” Adams said.
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Consumers just aren’t happy
Consumers feel bad — even though the national jobless rate was a mere 3.6% in May — because they have far less money to spend when everyday expenses, including rent, food and car payments, rise dramatically.
University of Michigan economist Don Grimes said he’s tended to have a higher forecast for inflation than most colleagues.
Even so, he said, “inflation has been even higher and more persistent than I thought.”
“Everyone seems to be underestimating inflation, and it is only a matter of the size of the error, not the direction of the error.”
Fighting the uptick in gas prices isn’t easy because it will be tough to boost supply, Grimes said. “Nobody is going to want to invest in developing new wells or refineries if they think that the demand for fossil fuels will be diminishing over the next few years,” he said.
Demand has been brisk up until lately in many areas. Real consumer spending was up 5.2% in the United States on a per capita basis between February 2020 and April 2022, Grimes said, even though people weren’t making a great deal more money. Real disposable personal income per capita was only up 0.2%.
People were able to spend more because of the massive federal stimulus programs, including three rounds of stimulus cash being sent to households and relief that included a payment pause on student loan debt that currently runs through Aug. 31.
“They accumulated over $2 trillion in excess savings in 2020 and 2021 due to government checks and an inability to shop during the worst months of the pandemic,” Grimes said.
All that savings can help cushion economic blows but it also makes putting a stop to inflation more complicated.
Thanks to inflation and no more stimulus money being sent to homes, Grimes said, this year real disposable personal income per capita is on track to see the largest decline — 5.6% — since 1932 during the Great Depression.
That’s why people are so unhappy, he said. Rampant inflation and higher prices make it feel like they’re already dealing with a recession.
“Will consumers gradually pull back as they run through that accumulated savings, or will the Federal Reserve need to engineer a recession so that real disposable income declines even more?” Grimes asked.
Eventually, he said, inflation will go down substantially and not stay at 8% or more. But it’s anyone’s guess how quickly the economy will get there and what it will take.
Consumers could voluntarily cut back their spending. Or they might end up involuntarily reducing their spending as they lose their jobs due to a recession.
“Wall Street looks like it’s betting on the recession method to reduce demand,” Grimes said.
The Standard & Poor’s 500 index officially fell into bear market territory Monday after falling more than 20% this year from its all-time high set in January.
Consumers see worse financial picture
Consumer sentiment hit its lowest recorded level between May and June based on preliminary data released Friday by the University of Michigan Surveys of Consumers. Sentiment has tumbled by 41.3% year over year.
The reading is comparable with the trough reached during the 1980 recession, wrote Joanne Hsu, director of the much-watched Surveys of Consumers.
Consumers are upset about high gas prices, inflation and shortages of items that they want to buy. “Consumers’ assessments of their personal financial situation worsened about 20%,” according to the report. The final report will be released June 24.
Consider that it would take you about $11,300 in 2022 in general to buy the same goods you could have bought for $10,000 two years ago, according to the Inflation Calculator at the Federal Reserve Bank of Minneapolis site. And even that is a lowball figure. The calculator only has been updated with data through March 31. An update with second quarter data is expected in July.
Like it or not, consumers must hand over more money to buy practically anything. Many are forced to cut back elsewhere on spending to cover necessities.
Now, they’d be wise to have a backup plan for the possibility of a recession, too.
ContactSusan Tompor via email@example.com. Follow her on Twitter@tompor. To subscribe, please go to freep.com/specialoffer. Read more on business and sign up for our business newsletter.