Fed faces crucial interest rate decisions, and any missteps could tip economy into recession

After keeping interest rates near zero since early in the pandemic to heal the economy and bolster the job market, the Federal Reserve has transformed suddenly into an inflation-fighting machine.

The Fed on Wednesday is expected to signal that it likely will raise its key rate from just above zero in March, its first bump in more than three years. The move would kick off what will likely be a series of at least three hikes this year, and possibly as many as seven, at least according to one research firm.  

With growth and inflation already set to slow this year, the central bank’s newly aggressive stance is raising concerns that it could move too abruptly and tip the economy into another recession. Already, the Fed's anticipated moves have spooked investors and played a big role in the stock market's selloff this month.

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Federal Reserve Chair Jerome Powell

Fed risking a recession?

“The risk is that they just go too much and they don’t need to,” says economist Kathy Bostjancic of Oxford Economics.

That would not be unusual. Curtailing inflation without halting an economic expansion requires a deft touch. The last time inflation was at least this high, in the early 1980s, the Fed hiked rates too sharply, plunging the nation into two recessions.

Just a few months ago, the Fed was set on keeping its benchmark rate near zero to juice borrowing and economic activity and bring more Americans back into the labor force. The nation is still 3.6 million jobs short of its pre-pandemic level and the labor force participation rate – the share of people working or looking for jobs – is at 61.9%, well below the pre-crisis mark of 63.4%.

Many workers on the sidelines fear COVID or are struggling to find child care, switching careers, or living off stimulus checks or enhanced unemployment benefits.

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The Fed on Wednesday is expected to signal that it likely will raise its key rate from just above zero in March, its first bump in more than three years.

Boosting interest rates

But Fed Chair Jerome Powell recently said it likely will take longer than anticipated for Americans to return to the labor force and top economists say that many people, such as millions of early retirees, never will.

As a result, with unemployment falling to 3.9% in December — not far above its pre-COVID level of 3.5%, a 50-year low — the Fed is expected to say Wednesday that the economy has reached the Fed’s goal of full employment, Oxford and Barclays say.

Since the Fed already has said the economy has met the Fed’s target of inflation hovering above 2% “for some time,” the twin milestones would open the door to a March rate increase. In a statement after a two-day meeting, Barclays predicts the Fed will say it will boost its key rate “soon.”

Although the central bank will likely note the recent slowdown in the economy, officials likely will write it off as the temporary effects of COVID’s omicron variant, Barclays says.

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Inflation surging

Powell also has shifted his view of inflation, which hit a 40-year high of 7% in 2021. For many months last year, he called the price surges “transitory” and linked them to the pandemic and reopening economy, with items such as used cars, hotel rates and airline fares bearing the brunt of the spiraling costs.

But at a congressional hearing in late November, he acknowledged that higher prices were affecting a broader range of products and services, and the supply-chain bottlenecks behind much of the advances could linger well into next year. The following month, the Fed accelerated the phaseout of its bond-buying stimulus – which has kept long-term rates low – to clear the way for earlier and faster rate increases.

How many rate hikes in 2022?

In December, Fed officials forecast three rate hikes this year but fed fund futures markets are expecting four.

Goldman Sachs economist David Mericle says there’s a risk the Fed could hike more than that, possibly even at each of the seven remaining meetings this year, though he acknowledges that “few Fed officials appear to be considering it for now.”

“If we have to raise interest rates more over time, we will,” Powell told the Senate Banking Committee earlier this month.

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“The Fed has pivoted from being patient to panicked on inflation in record time,” says Diane Swonk, chief economist of Grant Thornton.

Bostjancic traces the Fed’s urgency in part to its apparent complacency about inflation last year.

“The challenge is they could be behind the curve and have to move more aggressively than markets expect,” Bostjancic says.

If the Fed waits until the second half of the year to lift rates,“I think there’s risk of inflation pressures remaining elevated” for the longer term, says Gus Faucher, chief economist of PNC Financial Services Group.

Such a delay also could solidify higher inflation expectations among workers and employers, which itself could push up prices, Bostjancic says. “(Fed officials) have no choice,” she says.

Making a slowdown worse

Here’s the risk: The Fed will be hoisting rates just as growth is set to slow, from an estimated 5.5% last year – highest since 1984 – to a still-healthy 4% this year, according to Fed forecasts. Economists trace the pullback to a sharp drop in federal aid to households, the depletion of Americans’ excess cash and a natural return to normal. The reopening economy, after all, unleashed pent-up demand and consumers stuck at home snapped up lots of TVs, furniture and other goods.

Faucher says the economy is robust enough to withstand several rate increases.

But Joseph LaVorgna, chief economist of the Americas for research firm Natixis, expects a sharper slowdown to just 2% growth this year that leaves the economy more vulnerable to higher rates.

“You can only buy so many washers, dryers ” and other goods, says LaVorgna, who was a top economic advisor to former President Trump.

Meanwhile, as COVID eases, the supply snags and labor shortages that have driven up prices and wages are also expected to abate, economists say. There’s a chance the Fed could be raising rates “at just the wrong time,” Bostjancic says.

Also, some economists don't believe the nation is at full employment and that millions more could come back to the labor market. 

Even if the Fed raises rates four times, as markets expect, “That’s going to cause a recession,” LaVorgna says.

Economic recovery not threatened

Bostjancic and Mericle say it will take more hikes than that to threaten the recovery. And Faucher says the Fed can pause its rate increases by mid-year if the economy and inflation are slowing significantly.

The task, however,  becomes tougher if such a pullback doesn't happen until later in the year, Bostjancic says. 

That's why a Fed that's trying to tame high inflation faces a delicate balancing act.