April 2022 / Vol. 27 No. 4
By Fred Ashton, Senior Economist, NEMA
On March 16, 2022, the Federal Reserve approved its first interest rate hike in more than three years. After slashing interest rates to nearly zero at the onset of the COVID-19 pandemic, the Federal Open Market Committee (FOMC) raised the Federal Funds Rate 0.25 percent, or 25 basis points, into a range of 0.25 percent to 0.5 percent. The committee also penciled in six more quarter-point rate hikes in 2022, as seen in the nearby graph.
The move came amid a 40-year high in consumer price inflation of 7.9 percent in February compared to the same period a year ago. Energy has been the largest contributor, rising 38 percent in the 12-month period. Food prices (+7.9 percent), shelter (4.7 percent), and the price of used cars and trucks (+41.2 percent) have all challenged household budgets. While the Fed prefers to strip out volatile food and energy prices, core inflation, shown in the nearby graph, still measured 6.4 percent compared to February 2021, well above the Fed’s 2 percent target.
Projections for the federal funds rate made by each member of the FOMC — often referred to as the dot plot — showed a stark difference in the outlook for monetary policy from the December 2021 meeting. At the December meeting, most members believed that the appropriate interest rate target range would be between 0.75 percent and 1 percent by the end of 2022. At the March meeting, that range moved to 1.75 percent to 2.00 percent.
The new dot plot also shows a heightened level of uncertainty among the committee members. The difference between the low estimate of the target range of 1.25 percent to 1.5 percent and the high end of 3.0 percent to 3.25 percent widened compared to December, casting doubt over the path the FOMC will take. The lone member of the committee who voted against the policy action was Federal Reserve Bank of St. Louis president James Bullard, who wanted a 50 basis point increase.
The goal of a hike in the federal funds rate is to increase the cost of borrowing in the economy. Higher rates will inject discipline in investment decision-making, helping to weed out proposals with return-on-investment projections below the rising cost of capital. As investment declines, the amount of money circulating in the economy shrinks, slowing demand and economic growth, reducing inflation pressures. A significant downside is the rising cost of debt service for companies that opted to finance investment with low-interest loans over the last couple of years. With nonfinancial corporate debt of more than $11.5 trillion, businesses will soon face higher borrowing costs on newly issued debt and higher payments to service existing debt. The need to carry rising debt service costs as a slowing economy shrinks revenue growth will challenge business resiliency, just as many companies are recovering from the impact of the business lockdowns of 2020.
The pace at which the FOMC will hike rates this year is all but certain. Federal Reserve Chair Jerome Powell said in a recent speech given to the National Association for Business Economics, “if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
Because changes to monetary policy sometimes lag, the uncertainty and aggressiveness over the path of rate hikes leave the possibility of a policy mistake that could threaten continued economic growth.
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