Many consumers haven’t seen the Federal Reserve get this aggressive with hiking interest rates before.
Expectations are growing that the U.S. central bank will hike interest rates by a whopping 3 percentage points this year. By sheer number of hikes, that would be the most active Fed since 2005. But by the size and magnitude of each hike, it would be even more notable. The Fed hasn’t adjusted interest rates that much since the 1980s — the last time inflation became a major problem for the financial system.
Officials are expected to raise interest rates by half a percentage point for the first time since 2000, when they wrap up their May Federal Open Market Committee (FOMC) meeting. Investors, meanwhile, are wondering whether even more massive rate hikes will be on the table for the months ahead, including a three-quarter-point hike for June. If so, that would be the Fed’s most aggressive rate hike since 1994.
To make 2022 an even busier year for Fed policy, officials are going to start shrinking their massive portfolio of nearly $9 trillion in bonds, at a likely maximum pace of $95 billion per month.
The ultimate risk, however, is that the U.S. central bank does more harm than good to an economy that’s already experiencing its worst consumer inflation since December 1981.
Controlling inflation is top of mind for Fed officials, but the danger is that the Fed could tighten its way into a slowdown, slowing the economy too quickly and vacuuming too much liquidity all at once. Fiscal stimulus is also fading, while the economy is expected to settle back in at trend-line growth over the next two years, a pace destined to be historically tepid considering longer-run trends of an aging population and globalization. Supply bottlenecks and shortages are also to blame for inflation, which the Fed can’t directly control by raising interest rates.
“The economy doesn’t need the training wheels anymore, but you don’t want to just rip them off,” says Ryan Sweet, senior director of economic research at Moody’s Analytics. “The Fed needs to ease into this. It’s going to be a very challenging year.”
Markets fear that defeating inflation means starting recession
Fears of a recession are far and wide right now. One such example: The 10-year Treasury yield on March 31 traded below the 2-year rate for the first time since 2019. Known as the yield curve, the inversion has long been used as a Wall Street recession indicator.
When one flips, it shows that investors are expecting a downturn — and it also makes the flow of credit more restrictive when long-term borrowing is cheaper than short-term rates.
Markets have also been uneasy so far in 2022, as investors wrestle with those building recession risks. The S&P 500 is down nearly 13 percent so far this year, while an index tracking market volatility out of the Chicago Board Options Exchange is up 75 percent so far this year.
Part of the anxiety about inflation all along has been that a downturn is its only cure, likely informed by markets’ bad experiences during the stagflationary-era of the 1970s and 1980s.
Back then, the Fed manufactured what was at the time the worst recession since the Great Depression, hiking its benchmark borrowing rate all the way to a 15-20 percent target range. The idea that expansions don’t just die of old age has long been the lore on Wall Street.
“Not only is it a concern, but the odds favor it,” says Greg McBride, CFA, Bankrate chief financial analyst, referring to recession risks. “Look at the last three [tightening] cycles: Two of them ended in recessions, and the one that didn’t was an economic slowdown, where they had to reverse course and start cutting rates. History is not on their side.”
How aggressive will the Fed be in hiking rates during 2022?
That might be a point in favor of going aggressive at some of the Fed’s upcoming meetings, McBride says. Raising interest rates in one or two half-point moves might give the Fed more time to wait and see how the economy evolves.
“An ounce of prevention is worth a pound of cure,” McBride says. If the Fed front-loads rate hikes, “they don’t have to continue to raise interest rates as long or raise them as high and flirt with a much more significant economic fallout.”
Fed Chair Jerome Powell himself admitted in an April public appearance that this so-called “front-loading” of interest rate increases could let the Fed be more nimble down the road, preventing them from raising rates too much.
The Fed is “methodically” raising rates to the point that they’re no longer stimulating the economy, as Fed Vice Chair Lael Brainard also put it in April. Known as the neutral rate of interest, officials have pinpointed the level to be a 2.5 percent federal funds rate.
Yet, inflation is more than three times higher, meaning officials may very well have to take borrowing costs well above that threshold.
How big the Fed gets with rate hikes depends, in part, on consensus. Other corners of the Fed are worried about the risk of raising interest rates too aggressively. While the Fed might agree right now on the need to raise interest rates, agreement may become more difficult the higher rates get.
“If we raise rates really aggressively, we run the risk of slamming the brakes on the economy, putting the economy into recession,” said Minneapolis Fed President Neel Kashkari in a February town hall. Kashkari is one of the Fed’s most dovish members. “We’d be crashing back down into this low inflation environment.”
Fed’s rate moves depend on inflation and employment data
All of that shows the Fed’s rate hike pace depends on how the economy evolves. As of March, Fed policymakers saw inflation drifting down to 4.3 percent later this year, though that was before the Department of Labor’s consumer price index (CPI) showed that prices rose to a fresh 40-year high of 8.6 percent in March.
While some downward movement is expected as the pandemic and supply chain bottlenecks recede, the prospect that inflation lingers for longer is also high, in part because of lingering COVID-19 lockdowns abroad and the ongoing conflict in Ukraine. Gas prices have since moderated from their record highs in March, but they’re still historically elevated at an average of $4.19 per gallon, up $1.29 from a year ago, according to AAA.
Other indicators point to a broadening out of inflation. Many workers are starting to ask for pay increases to account for rising living costs, while a historically tight labor market has led many firms to boost wages. Over the past 12 months, wages and salaries among private-sector workers are up 5 percent, the biggest increase on record, according to data from the Department of Labor.
Even more blockbuster, employers added 431,000 jobs in March, suggesting hiring remained resilient despite a surge in new virus cases during the Omicron wave.
The case for being patient: Rate hikes take time to impact the economy
On the other hand, higher interest rates take time to filter into the economy. Experts say it may take a year for the full effect of a rate hike to be realized, raising the risk that the Fed tightens too much.
“If you’re balancing risks and you get less worried about the economy slowing and more worried about inflation just staying high and getting built in to the price and wage-setting process, then you might conclude you need to move faster,” says Bill English, finance professor at the Yale School of Management who spent 20 years at the Fed. “Lags just make the problem harder because you have to be forward-looking and judge where the economy is going to be.”
What to do with your money when rates are expected to rise
It’s not a question of whether rates will go up — but by how much. Take steps now to prepare your finances for a new era of monetary policy, one that will mean more expensive borrowing costs down the road.
- Pay down debt: Consumers with fixed-rate debt won’t feel any impact from a Fed rate hike, but you are more fragile if you have a variable-rate loan. Prioritize paying down that debt, especially a high-interest credit card balance. Consider consolidating that debt with a balance transfer card or to help you make a bigger dent on your principal balance. Homeowners with an adjustable-rate mortgage or a home equity line of credit (HELOC) might be wise to refinance into a fixed-rate loan. “You don’t want to be a sitting duck for higher interest rates on your credit card or home equity line of credit,” Bankrate’s McBride says.
- Take steps to bolster your earnings opportunities: Now’s the time to start maximizing your income to hopefully beat inflation. Take advantage of a historically tight job market to negotiate for higher pay. That might involve hunting for a new position, which has been known to give workers bigger pay gains.
- Boost your emergency savings and find the best place for your cash: High inflation shouldn’t keep consumers from building up an emergency cushion of cash in case of emergencies or unplanned expenses. In fact, rising recession risks only underscore the urgency. Do, however, shop around for the best yield on the market. Online banks tend to offer higher yields for your cash than traditional, brick-and-mortar institutions.
- Think about recession-proofing your finances: Given that plenty of risks lie ahead for the Fed, always be on the lookout for ways that you can recession-proof your finances. Along with building up your emergency fund, experts say it comes down to living within your means, staying connected with your network, identifying your risk tolerance and staying focused on the long haul, if you’re an investor.
“It’s going to be a very challenging task to land this plane perfectly on the tarmac,” Moody’s Sweet says of the Fed’s efforts. “There’s going to be a lot of bumps, where the Fed has to back off on rate hikes or accelerate rate hikes. It’s very unlike the last tightening cycle.”