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A trader works, as Federal Reserve Chair Jerome Powell is seen delivering remarks on a screen, on the floor of the New York Stock Exchange in New York City on May 4.BRENDAN MCDERMID/Reuters

The U.S. Federal Reserve announced its largest interest rate hike in two decades on Wednesday and signalled that more oversized rate increases are coming, a move that reverberated through global markets and will set the tone for central bankers around the world.

The Federal Open Market Committee, which manages U.S. monetary policy, voted unanimously to increase the central bank’s policy rate by half a percentage point, instead of the usual quarter-point move. It said that in June it will begin shrinking the Fed’s $9-trillion balance sheet, which is loaded with assets purchased during the pandemic to keep interest rates at rock bottom. This will further push up borrowing costs.

The widely anticipated move puts the world’s most influential central bank on track to reduce monetary stimulus at the fastest pace in decades in the hope of preventing high inflation from becoming entrenched. The massive size of U.S. financial markets means that changes by the Fed affect credit conditions around the world.

The announcement also consolidated a pivot by the central bank, which has gone from arguing last fall that high inflation would be “transitory” to promising a series of oversized rate increases.

Fed chair Jerome Powell said he expects the committee will consider increasing the policy rate by 50 basis points at each of its next two meetings, which would bring the Fed Funds rate back above prepandemic levels by the middle of the summer. At the same time, he seemed to rule out an increase of 75 basis points, saying that “is not something the committee is actively considering.”

This puts the Fed largely in line with the Bank of Canada, which raised its policy rate by 50 basis points in April to 1 per cent, and signalled that another half-point rate hike is on the table for its upcoming meeting in June.

The United States is grappling with the highest inflation in 40 years, with annual growth in the consumer price index hitting 8.5 per cent in March. Demand is outstripping supply in the U.S. economy, which is showing up in the fact that companies cannot get enough workers and wages are rising rapidly. A global commodity price shock caused by Russia’s invasion of Ukraine has further increased prices for products like gasoline and food.

Stock markets responded positively to the Fed’s announcement and Mr. Powell’s suggestion that the central bank is not considering a move of 75 basis points. The S&P 500 index finished the trading day up 2.99 per cent, and the Dow Jones Industrial Average ended up 2.8 per cent – notable reversals after a months-long sell-off in equity markets.

Persistently high inflation and the prospect of rapid rate hikes have caused turmoil in global markets in recent months. Stock markets have tumbled as investors shed riskier assets, and bond prices have fallen as investors adjust their fixed-income portfolios to account for more rapid rate increases. Yields on two-year U.S. treasury bonds have more than tripled since the start of the year. (Bond yields and prices move in opposite directions.)

Some economists are warning that the Fed risks tipping the U.S. economy into a recession if it moves too quickly to cool demand. The Fed does not have a good track record of increasing interest rates without choking off growth.

Mr. Powell played down these concerns, arguing that the U.S. economy is strong enough to sustain higher borrowing costs.

“I think we have a good chance to have a soft or soft-ish landing,” he said. “But I do expect that this will be very challenging. It’s not going to be easy. And it may well depend, of course, on events that are not under our control.”

The key to a soft landing is cooling the job market without causing a spike in unemployment. Mr. Powell said this is possible because the number of job vacancies is elevated. There are nearly twice as many job openings as there are unemployed Americans, which theoretically gives the Fed room to curtail demand for labour without causing businesses to cut existing jobs.

Bank of Canada governor Tiff Macklem has made a similar argument about the Canadian labour market, which is also at historically tight levels.

Brian Coulton, chief economist at Fitch Ratings, said the hawkish tone of the announcement increases the risk that the Fed will push rates up to restrictive levels and cause an economic downturn.

“Their singular focus on trying to control inflation is not only spelled out explicitly – with the committee described as being ‘highly attentive’ to inflation – but is also reflected in short shrift given to the [first quarter] GDP decline and the rapid pace of balance-sheet reduction ahead,” Mr. Coulton said in an e-mailed statement.

“With inflation pressures ongoing, the risk of monetary tightening prompting a significant growth slowdown or even recession in 2023 is growing,” he said.

Moody’s Analytics senior director of economics research Ryan Sweet had a more optimistic take on the prospect of a soft landing.

“Just because a recession followed a Fed tightening cycle doesn’t mean the central bank was the primary cause of the downturn. Each of the past three tightening cycles, the Fed was not the primary cause of the economic downturn,” he wrote in a note to clients.

“Another reason to hope that the Fed can pull off a softish landing is the health of consumer and nonfinancial corporate balance sheets. Household debt service and financial obligation ratios are low, and in aggregate, consumers are sitting on $2.6-trillion in excess savings. This could help cushion consumer spending as the economy softens in response to the Fed’s aggressive tightening cycle,” he wrote.

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