US Federal Reserve poised to shift to quarter-point rate rise as inflation eases

The US Federal Reserve increased its benchmark interest rate by a quarter of a percentage point on Wednesday but warned “ongoing increases” would be needed to bring inflation under control.

The shift down to a quarter-point increase marked a return to a slower, more orthodox pace of rate rises after the Fed rapidly ratcheted up borrowing costs last year, and reflected the fact that inflation appears to have peaked while the economy is starting to slow.

However, in a statement, the Fed maintained that “ongoing increases in the target range will be appropriate” in order to ensure it is restraining activity enough to bring price pressures under control. That indicated the central bank is inclined to raise borrowing costs further at its next meeting.

The Federal Open Market Committee’s latest increase brings the federal funds rate to between 4.5 per cent and 4.75 per cent, the highest level since September 2007. The Fed added that while inflation had “eased somewhat”, it still remained “elevated”.

In a press conference, Fed chair Jay Powell said while there had been some “encouraging” signs that price pressures were easing, policymakers “will need substantially more evidence to be confident that inflation is on a sustained downward path”.

Powell signalled that Fed officials remained chiefly concerned about the risks of doing too little to tame inflation rather than squeezing the economy too much.

“It’s very difficult to manage the risk of doing too little and finding out in six or 12 months that we actually were close but didn’t get the job done,” he said. “If we feel like we’ve gone too far . . . inflation is coming down faster than we expect, then we have tools that would work on that.”

He added: “You know, the job is not fully done . . . so I think it would be premature . . . very premature to declare victory.” He also appeared to rule out pausing rate rises and restarting them at a later date, indicating the central bank would prefer to implement all the tightening in one cycle.

Despite Powell’s comments, markets rallied sharply during and after the press conference as traders focused on a smattering of dovish notes from the Fed chair, including the fact he could say “for the first time the disinflationary process has started”.

Some investors were encouraged by Powell’s more relaxed response to a recent easing of financial conditions, saying that the Fed’s focus “is not on short-term moves”.

The benchmark S&P 500 and tech-heavy Nasdaq rose to the highest levels since August and September 2022, respectively. Investors bought Treasury bonds, with the two-year Treasury yield, which moves with interest rate expectations, falling to its lowest level in two weeks. 

The dollar index, which measures the greenback against a basket of six currencies, fell to its lowest level since April 2022. 

The quarter-point increase represented a break with the unusually large half and three-quarter-point rate rises the Fed relied on in 2022 as it wrestled with soaring inflation. By contrast, the European Central Bank and the Bank of England are expected to increase rates by 0.5 points on Thursday.

Bob Michele, chief investment officer at JPMorgan Asset Management, said that the statement was “very hawkish” but that the press conference was more dovish because Powell acknowledged it would take time for the full effect of rate rises so far to feed through to the economy.

“They’re getting close to the end of the hiking cycle,” said Michele. “We think they will do a 0.25 percentage point increase in March, which will be the last hike. [Powell] undid everything in the press conference, which is why you got the reaction you did in markets.”

In December, most officials projected the fed funds rate would peak at between 5 per cent and 5.25 per cent this year and for that level to be maintained throughout 2023.

Fed officials have stuck to that thinking in recent weeks. If the path they set out in December still holds, it suggests the central bank will implement two more quarter-point rate rises beyond Wednesday’s increase.

But policymakers have been unable to convince money managers and traders in fed funds futures markets. The market is pricing in a peak rate just below 5 per cent in the second quarter and 0.5 percentage points of cuts by the end of the year. 

That has set the stage for what Tobias Adrian, the IMF’s head of monetary and capital markets, warned could be a shock if the inflation data disappoints in the future and the Fed tightens further as a result.