Federal Reserve officials delayed their campaign to cool the economy on Wednesday, but indicated that interest rates would rise higher than previously expected in 2023 as inflation proves to be more stubborn than policymakers had hoped.
Fed officials voted unanimously at the end of their two-day meeting to raise borrowing costs by half a percentage point, a drop after four consecutive three-quarter point increases. Their policy rate is now set at a range of 4.25 to 4.5 percent, the highest since 2007.
After months of moving quickly to make money more expensive in an attempt to contain an overheated economy, central bankers are entering a phase where they expect to adjust policy more cautiously. That gives them time to see how the labor market and inflation react to the policy changes they have already made.
Still, the Fed’s latest economic forecasts, released on Wednesday for the first time since September, sent a clear signal that slowing the pace of rate hikes does not mean officials are giving up their fight against rapid inflation. Borrowing costs are expected to rise more dramatically and cause more economic pain than central bankers previously expected as policymakers try to counter stubborn price increases.
“We have consistently expected to progress faster on inflation than we have done,” said Jerome H. Powell, the chairman of the Fed, during his post-release press conference. He described the Fed’s new expectations as “slower progress on inflation, tighter policies, probably higher rates, probably held longer, just to get you to the kind of constraint that’s necessary to bring inflation down to 2 percent.”
Officials now expect to raise their policy rate to 5.1 percent by the end of 2023, which would represent another three-quarters of a point of adjustment and would be half a percentage point higher next year than officials had previously expected. Policymakers also expect to keep borrowing costs high for longer.
“We have more work to do,” said Mr. Powell.
The Fed’s higher interest rates are expected to significantly cool the economy next year. Central bankers predict that unemployment will rise from 3.7 percent now to 4.6 percent and remain high for years to come. Growth in 2023 is expected to be much weaker than previously expected, pushing the economy to the brink of recession.
“I don’t think anyone knows if we’re going to have a recession or not, and if we do, whether it’s going to be a deep one or not,” said Mr. Powell. “It is unknowable.”
The central bank’s aggressive stance comes as central bankers worry that inflation will remain high for years to come. While price increases are already starting to level off from the highest levels in four decades, which they reached this summer, the Fed’s economic projections make it clear that policymakers believe it will take years for inflation to fully return to its target of 2 per cent.
Despite the Fed’s tough talk, investors appeared unconvinced on Wednesday. Stock prices in the S&P 500 fluctuated higher and lower as Mr. Powell spoke at a news conference before finishing the day with 0.6 percent.
And while the Fed expects to keep rates above 5 percent through the end of 2023, investors are still betting that the central bank will stop raising rates sooner and start lowering them sooner.
“Financial markets want black and white, and you work in shades of gray,” said Diane Swonk, chief economist at KPMG, explaining that investors are not internalizing the Fed’s nuanced message.
That divergence could be a problem for central bankers. Higher stock prices and lower market interest rates make money cheaper and easier to borrow, stimulating the economy — the opposite of the Fed’s goal of reducing inflation.
“You hear the mantra ‘Don’t fight the Fed,’ but right now the market is willing to fight the Fed,” said Stephen Stanley, chief economist at Amherst Pierpont Securities. “It’s an interesting dissonance that poses a risk to the market.”
Mr Powell has repeatedly emphasized his central bank’s determination to keep fighting inflation until it is fully overcome, and on Wednesday underlined that it will likely take some time to get price pressures back under control.
The Fed has recently received evidence that inflation is moderating, including in new consumer price index data released Tuesday. Economists have been waiting for months for rapid increases in the price of goods – from used cars to clothing – to slow down as supply chains recover, which seems to be finally happening. Housing inflation will also cool in 2023, as a recent slowdown in market-based rents is reflected in official data, which should start to moderate services inflation.
But mr. Powell said at his news conference that Fed officials need “substantially more evidence” to be sure inflation is on a sustained downward path.
In particular, a stronger economic slowdown may be necessary for rapid increases in service prices to completely disappear. The labor market is very strong and wages are rising rapidly, which means that prices for things like hairdressing, restaurant meals and financial aid can continue to rise. That’s because as they pay their employees more, companies are likely to charge more to protect their profits.
“We’re seeing a very, very strong labor market, one where we haven’t seen much easing,” said Mr. Powell. “There’s a real imbalance in the labor market between supply and demand, so that part of it, and that’s most of it, is probably going to take a significant period of time to work out.”
Mr Powell said: “That’s really why we’re writing those high rates and why we expect they’re going to have to stay high for a while.”
Even if the Fed can bring the economy down relatively gently, officials expect their path will cause at least some pain in the labor market. While that is an unappealing prospect, central bankers believe it is necessary to prevent price increases from starting to feed on themselves.
As consumers become accustomed to rapid inflation and begin to demand larger increases, and firms make larger and more regular price adjustments to cover rising input and labor bills, rapid price increases may become commonplace.
In the 1970s, officials allowed inflation to remain faster than normal for years, leading to what economists have since called an “inflation psychology.” When oil prices spiked for geopolitical reasons, an already high inflation base and high inflation expectations helped drive price increases dramatically. Fed policymakers eventually raised interest rates to nearly 20 percent and pushed unemployment into double digits to bring prices back under control.
Officials today want to prevent a repeat of that painful experience. That is why they have indicated that they do not want to give up the fight against inflation too soon.
“I wish there was a completely painless way to restore price stability,” said Mr. Powell. “There isn’t.”
