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May Fed meeting preview: Ready for the biggest rate hike since 2000? Watch for these 4 things

Federal Reserve Chair Jerome Powell illustration over Fed building
Images by Getty Images; Illustration by Bankrate
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Consumers saw a Federal Reserve willing to pull out all the monetary policy stops during the coronavirus crisis, as officials rushed to revive a cratered economy. Now, they’re about to see the same Fed — just with the opposite intent in mind.

Policymakers on the Federal Open Market Committee (FOMC) are expected to raise interest rates by a supersized half-percentage-point hike when they wrap their next May 3-4 rate-setting meeting. It would mark the first rate increase of such magnitude since 2000. That expected bump breaks from the previous tightening cycle’s tradition of gradually tapping the brakes on the economy in quarter-point baby steps. It’s also the first time in 16 years that officials have hiked borrowing costs at back-to-back gatherings, after the U.S. central bank’s quarter point rate hike in March.

Also on deck, the U.S. central bank could announce plans to start shrinking its near $9 trillion bond portfolio at a likely pace of $95 billion a month, according to records of the Fed’s March gathering. If so, that would be nearly twice as fast as the previous time officials delved into trimming the money supply in 2017. Experts say the move could zap even more stimulus from the financial system, translating to even higher mortgage and long-term borrowing rates for consumers.

Officials are far less patient with unwinding accommodation than previous cycles amid boiling inflation. Prices in March soared to a fresh 40-year high of 8.5 percent from a year ago, nearly four times higher than Fed officials’ desired 2 percent level and impacting many items in consumers’ monthly budgets, from groceries and appliances, to gasoline, energy and rent.

Consumers very well could see an even more aggressive U.S. central bank down the road if investors’ expectations come to fruition. Market participants are bracing for the Fed to hike at all six gatherings this year, with a 75-basis-point increase on the table for June. That rate jump would be the biggest move since November 1994 and the second of its kind.

“Rising interest rates are not going to be a factor of quarter points or half points; it’ll be measured in percentage points by the time this is all said and done,” says Greg McBride, CFA, Bankrate chief financial analyst. “The cumulative effect is what matters and that cumulative effect is going to be growing presumably at a pretty rapid clip.”

Here’s what to know about next week’s Fed meeting, including steps you should take with your money.

1. Brace for a giant half-point rate hike for the first time since 2000

Fed Chair Jerome Powell is rallying behind the need for a more aggressive rate hike with the idea that moving faster out of the gate could prevent U.S. central bankers from tightening too much, dangerously restraining growth.

“It is appropriate in my view to be moving a little more quickly,” Powell said in an April 21 public appearance. “I would say 50 basis points will be on the table for the May meeting.”

That’s because officials may be able to move a few times and then back off, rather than gradually hike interest rates for an extended period of time in smaller, quarter-point increments, says Lindsey Piegza, chief economist at Stifel.

“The Fed may shock the market with a series of larger increases but shorten the duration of the accommodation removal timeframe,” she adds.

Officials have a destination in mind: They want to hike interest rates past the point in which they’re no longer stimulating growth. That threshold is the so-called “neutral rate of interest,” which was believed to be around 2.5 percent in the previous economic expansion.

“I see an expeditious march to neutral by the end of the year as a prudent path,” said San Francisco Fed President Mary Daly in an April 20 speech. She joins the ranks of other Fed officials, including Cleveland Fed President Loretta Mester, Richmond Fed President Thomas Barkin and Fed Governor Lael Brainard.

“If the Fed is going to get rates close to 2.5 percent by year-end, they can’t continue to do so at a quarter-point pace,” McBride says.

2. Fed expected to unveil plans to start trimming the balance sheet

Runoff from the Fed’s balance sheet will have another major effect on consumer borrowing costs — and some experts say that drawdown impact could be even greater than rate hikes.

The Fed’s balance sheet is a confusing corner of Fed policy, but officials essentially shrink the availability of money in the financial system when they start to trim their portfolio of securities. Those assets include both longer-dated Treasurys and mortgage-backed securities as well as shorter-term bills, their yields acting as another important consumer borrowing cost benchmark. That means loans at varying maturities could be impacted.

But how much the Fed’s supposed $95 billion drawdown could influence borrowing costs depends on demand, and the mechanics of it all aren’t fully realized considering that markets have only one other experience with such a program, often called “quantitative tightening.”

Bond yields and prices have an inverse relationship, meaning yields rise when demand drops. If no one steps in to fill the Fed’s shoes once the biggest buyer in the marketplace steps away, yields are likely to continue to chart their ascent. So far this year, for example, the 10-year Treasury yield has climbed 1.18 percentage points.

“It’s a little like taking oxygen out of the room,” McBride says. “There’s going to be less money sloshing around, so that means less economic activity, higher cost of borrowing, higher cost of capital to invest. All of that acts as a restraint on the economy and a pretty significant one, even if it is somewhat opaque.”

3. Borrowing costs are climbing at a faster pace than the Fed is raising interest rates

If the Fed hikes rates by 50 basis points, officials will have only nudged their benchmark federal funds rate higher by 0.75 percentage points so far this year.

Yet, consumers could feel an even tighter pinch, especially when it comes to mortgage rates. A Bankrate nationals survey of lenders found that the cost of financing a home has jumped by 2 percentage points on average, climbing to 5.22 percent in the week that ended on April 27. Bigger spikes than this one have happened before, according to McBride, but never one at this speed.

Long-term rates tend to move faster than the Fed because they reflect where investors expect the financial system to head over the life of the security, and a major factor influencing those expectations is Fed communication. In other words, the Fed can jawbone some rates up in the marketplace simply by telling investors it’s planning to be aggressive.

Even shorter-term borrowing rates are on the rise, though at a slower clip. The average annual percentage rate (APR) on a credit card jumped to a 2-year high of 16.4 percent in the week that ended on April 27, from 16.3 percent on Dec. 22, according to Bankrate’s national survey. More hikes could be on the horizon as the Fed increases its benchmark rate.

In other words, borrowing rates could only continue to climb at a faster clip the more aggressive the Fed gets.

If the outlook turns, however, the opposite could be true. Cooling inflation could prompt the Fed to signal it’s stepping back from its aggressive rate hike plans, and yields could fall when investors heed the message. Treasury rates could also fall if investors start to worry about a slowing economic environment as the Fed lifts rates.

“We are not convinced that peak hawkishness has passed,” says Lauren Goodwin, CFA, economist and director of portfolio strategy at New York Life Investments. Yet, she also expects that the market may have gotten ahead of itself with its rate hike projections, especially as the Fed also starts to shrink its balance sheet. “Expectations that the Fed will be able to hike its policy rate to around 3 percent by the end of this year might be difficult to actually happen.”

4. How high will the Fed be able to take rates?

One thing is for certain: If investors are bracing for a hawkish Fed, officials might have room to be more aggressive without choking markets. When the Fed signals upcoming rate hikes, investors respond to that news as if it’s already actually happened, meaning the Fed’s May hike could be all but priced in at this point.

“While the Fed does not care as much about the markets as they do about their policy mandates of stable prices and maximum employment, the market is one of the main transmission mechanisms in how said policy impacts those things,” Goodwin says.

That also means policy could pack a bigger punch, especially if the Fed judges that it doesn’t have to be as aggressive with rate hikes as they once expected.

“It’s akin to a high school student coming home and telling their mom, ‘I got a giant tattoo on my face,’ and then, ‘Oh, just kidding, I got my ears pierced,’’’ Stifel’s Piegza says. “You present this much larger, more drastic scenario, then all of a sudden, it makes the realistic scenario the path they’re actually taking less onerous.”

As Fed gets more aggressive, recession worries grow

But the Fed is going to have plenty of challenges to get interest rates at the right level. For starters, officials are dealing with inflationary supply chain bottlenecks, corners of the economy that they cannot directly influence or fix by raising interest rates. Considering that the global and domestic economy’s productive capacity is lower today than it was pre-pandemic, officials might have to take even more steam than usual out of the economy.

The higher rates have to climb, the faster the Fed slows the economy. Making the job even more complicated, each rate hike acts with a lag, sometimes taking around six months before fully filtering through the labor market and prices, according to Goodwin.

Adding another layer of complexity, experts point out that the Fed is behind the curve. Growth was already expected to slow dramatically from 2021’s blockbuster 5.7 percent pace, the fastest since 1984. Fed policymakers now see the U.S. economy expanding 2.8 percent in 2022, though growth could register even lower the more the Fed taps the brakes on growth. All of that raises the risk that the Fed could do too much, slamming the brakes on the economy — or worse, starting a recession.

“We’re not overheating; we’re moderate at best,” Piegza says. “When you look at the timing, arguably the economy is already at the peak or near the peak in terms of the economic cycle. The Fed tends to implement a removal of accommodation much later in the cycle than some would argue they should employ it.”

Some experts are also starting to point out that the neutral rate of interest could be much higher than 2.5 percent, considering that inflation is more than three times higher. Yet, the Fed was only able to take rates to 2.25 percent in the last expansion before eventually having to reverse course, walking back that tightening by cutting rates at three separate meetings in 2019.

Regardless of the economic outcome, consumers should prepare for a slowdown, bolstering their emergency savings and finding the best place to park their cash. Refinancing variable-rate debt into fixed-rate loans will also be a prudent step, as will shopping around for the most competitive rate on the market.

“They couldn’t even get rates to 2.5 percent back in 2018 before the economy slowed significantly and financial markets completely rolled over,” McBride says. “That was when unemployment was at a 50-year low and nobody had ever heard of COVID. The idea that they’re going to be able to raise interest rates to 2.5 percent or higher to corral inflation and not tip the economy into a recession is highly unlikely, borderline fantasy.”

Written by
Sarah Foster
U.S. economy reporter
Sarah Foster covers the Federal Reserve, the U.S. economy and economic policy. She previously worked for Bloomberg News, the Chicago Tribune and the Chicago Daily Herald.
Edited by
Banking editor