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Hiking to New Peaks

Jerome H. Powell, the chair of the Federal Reserve, testified before the Senate Banking Committee on Tuesday and signalled that the central bank is prepared to raise interest rates more than previously expected. Powell also suggested that the Fed could return to a quicker pace of rate increases if the latest economic data continue to show strength. This marks a clear shift from the Fed’s stance in December when it signalled a slower pace of rate hikes.

The Stubborn

Powell’s comments were a response to recent reports that suggest inflation has remained stubbornly high, while the job market continues to show resilience. The Fed raised interest rates by three-quarters of a point in 2022 but slowed to half a point in December and a quarter point in early February. Powell suggested that if incoming data, including the latest jobs report and inflation report, remain strong, the Fed would consider a faster pace of rate hikes.

Powell also acknowledged that the Fed’s fight against inflation was “very likely” to come at some cost to the labor market. He noted that while the job market has been resilient to the Fed’s moves so far, the strong wage growth is still inconsistent with a return to 2 percent inflation. Strong wage growth can cause companies to raise prices to cover their labor costs, and consumers may have more ability to sustain their spending, keeping demand strong enough to allow price increases to persist.

Powell’s remarks caused a stir in the financial markets, with investors increasingly betting that the Fed would make a half-point move instead of the previously expected quarter-point move at the Fed’s upcoming March 21-22 meeting. Stock prices lurched lower, and Wall Street’s widely watched recession indicator sounded its loudest alarm since the early 1980s. Yields on 2-year Treasury bonds rose more than a full percentage point higher than 10-year yields on Tuesday, the biggest inversion between the two since 1981.

The Fed last year raised interest rates at the fastest pace since the 1980s, pushing borrowing costs from near zero to above 4.5 percent. That move initially seemed to be slowing consumer and business demand and helping inflation to moderate. But a number of recent economic reports have suggested that inflation did not weaken as much as expected last year and remained faster than expected in January. Other data showed hiring remains strong, and consumer spending picked up at the start of the year.

A Bumpy Road

Powell suggested that the unexpected strength would probably require a stronger policy response from the Fed. “The process of getting inflation back down to 2 percent has a long way to go and is likely to be bumpy,” he said. “The latest economic data have come in stronger than expected, which suggests that the ultimate level of interest rates is likely to be higher than previously anticipated.”

The Fed’s stance on interest rates is crucial to the health of the U.S. economy. When the Fed raises interest rates, it slows consumer spending on big credit-based purchases like houses and cars and can dissuade businesses from expanding on borrowed money. As demand for products and workers cools, wage growth eases, and unemployment may even rise, further slowing consumption and causing a broader moderation in the economy.

In summary, Powell’s remarks before the Senate Banking Committee indicate that the Federal Reserve is prepared to raise interest rates more than previously expected in response to recent reports of stubbornly high inflation and a resilient job market. If incoming data continue to show strength, the Fed may even consider a quicker pace of rate hikes. That has many investors spooked, and rightly so.