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U.S. Federal Reserve Chair Jerome Powell speaks during a news conference on interest rates, the economy and monetary policy actions, at the Federal Reserve Building in Washington on June 15.OLIVIER DOULIERY/AFP/Getty Images

The U.S. Federal Reserve has announced its largest interest rate increase since 1994, and said that it would continue pushing borrowing costs higher in an effort to restrain the highest inflation in four decades.

Officials announced a 0.75 percentage point interest rate increase on Wednesday, lifting the benchmark federal funds rate to between 1.5 per cent and 1.75 per cent.

The move marks an abrupt shift at the world’s largest central bank, and suggests a willingness by the central bankers to squeeze the U.S. economy to prevent prices from spiralling further out of control.

Higher interest rates make borrowing more expensive for households and businesses, with the aim of reducing the amount of demand in the economy. This slows the pace of growth in consumer prices. But it can also lead to a recession if the central bank miscalculates and tightens monetary policy too much, curtailing consumer spending and business investment, and pushing up unemployment.

Bank of Canada would be wise to match U.S. Federal Reserve’s plans for aggressive rate hikes

The Fed’s interest rate hikes in recent months and increasingly hawkish language have already led to tighter credit conditions in the United States and around the world. Global borrowing costs tend to follow what happens in the U.S. That’s led to a decline in house prices in some markets and a sharp sell-off in financial assets such as stocks.

Fed officials had previously signalled that they would announce an increase of a half a point this week. But they were surprised in the days leading to the rate decision by data that showed the rate of inflation continues to march higher. It hit a 40-year-high of 8.6 per cent in May.

Reports published in recent days also showed that Americans are beginning to expect persistently high inflation – a situation that makes the Fed’s job of getting the rate of inflation back to 2 per cent much more difficult.

“We’ve been expecting progress [on inflation], and we didn’t get that, we got sort of the opposite,” Fed chair Jerome Powell said at a news conference after the rate announcement.

Inflation was already at a multidecade high at the start of the year, eating into U.S. wages and savings. Russia’s invasion of Ukraine has made matters worse by pushing global oil and food prices sharply higher in recent months.

This has forced central banks, including the Bank of Canada, to begin raising interest rates rapidly in the hope of preventing high inflation from becoming entrenched, as happened in the 1970s and early 1980s.

Mr. Powell said he did not expect moves of 75 basis points to become common. But he said the Fed would likely consider a hike of 50 or 75 basis points at its meeting in July, with the goal of getting interest rates to a “modestly restrictive level” by the end of the year. (A basis point is one 100th of a percentage point.)

Economic projections published on Wednesday show that Fed officials now expect the federal funds rate will rise to 3.4 per cent by the end of the year, and to 3.8 per cent next year. That’s a stark change from March, when officials expected the benchmark rate to hit 1.9 per cent by the end of the year and 2.8 per cent by 2023.

“We aren’t going to declare victory until we really see convincing evidence, compelling evidence that inflation is coming down,” Mr. Powell said.

After the Fed’s mega rate hike, stock markets vacillated between fear and relief, capturing the tortured relationship between equities and interest rates. Despite the Fed’s hawkish turn, the S&P 500 index gained 1.46 per cent on the day, while the S&P/TSX Composite Index advanced by 0.32 per cent.

This follows a dramatic sell-off on Monday, after the idea that the Fed would move 75 basis points became widespread in financial markets.

In general, equity investors prefer low rates – they make stocks more attractive than low-yielding bonds, and their economic effect tends to boost corporate earnings by making it cheaper to borrow.

This had been the case through the first two years of the pandemic, when emergency central bank action on rates helped orchestrate a monumental rebound in stock markets. From the lows of March, 2020, the S&P/TSX Composite Index roughly doubled over the next two years, while the S&P 500 index gained about 115 per cent.

Now, having lost control of inflation, central banks no longer have the luxury of coming to the stock market’s rescue as it has in the past, by slashing rates when appetite for risky assets such as stocks crumbles.

“The Fed’s primary goal is to tame inflation right now, and not to boost the equity markets,” Ipek Ozkardeskaya, senior analyst at Swissquote Bank, wrote in a note. “And depressed market conditions seem necessary in achieving that goal.”

But investors generally seem to have grasped that aggressive policy changes are required to conquer the worst inflation threat in a generation. Influential people in the U.S. financial community, such as activist investor Bill Ackman, have called for enormous rate hikes to restore the Fed’s credibility with financial markets.

The accelerated pace of interest rate hikes is risky. If the Fed tightens monetary policy too much, it could push the U.S. economy into a recession. The Fed’s updated economic forecast, published on Wednesday, doesn’t show the country’s economy falling into recession, but it does show growth slowing and unemployment rising.

The Fed now expects 1.7-per-cent annual GDP growth this year and next year, down from its March projection of 2.8-per-cent growth this year and 2.2 per cent next year. Meanwhile, it expects the rate of unemployment to rise from 3.6 per cent today to 3.9 per cent next year and 4.1 per cent in 2024.

“We don’t seek to put people out of work,” Mr. Powell said. “Of course, we never think too many people are working and fewer people need to have jobs. But we also think you really cannot have the kind of [robust] labour market we want without price stability.”

He said in May that he expects the U.S. economy can achieve a “softish” landing: reducing inflation without causing a sharp rise in unemployment. He reiterated this point on Wednesday, although he acknowledged that high oil prices and the conflict in Ukraine are making a soft landing harder to achieve.

“Many factors we don’t control are going to play a very significant role in deciding whether that’s possible or not,” Mr. Powell said. “There is a path for us to get there. It’s not getting easier, it’s getting more challenging.”

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