U.S. Federal Reserve officials tightened monetary policy more aggressively than expected just a week ago, as inflation reached highs unseen in 40 years.
On June 15, the Fed raised its benchmark federal funds rate by 75 basis points after recent data showed that surging commodity prices, the war in Ukraine and supply chain issues continue to boost inflation to levels not seen in decades.
"We are strongly committed to bring inflation back down, and we are moving expeditiously to do so," Fed Chairman Jerome Powell said during a press conference following the rate-setting Federal Open Market Committee's meeting.
Market observers expected the central bank to raise rates by 50 basis points until a June 10 report from the U.S. Bureau of Labor Statistics showed that the consumer price index, a key inflation measure, had jumped 8.6% from May 2021 to May 2022, the biggest rise in more than 40 years, and the University of Michigan's gauge of consumer sentiment fell to a record low.
The alarming data ended weeks of speculation that inflation had peaked and pushed the Fed to implement its largest rate hike since 1994.
The Fed has "shifted the baseline" for rate hike expectations, said Ryan Swift, a U.S. bond strategist at BCA Research, in an interview. The Fed will likely approve 50-basis-point raises at its next three meetings unless inflation numbers continue to come in higher than expected, Swift said.
"Eventually they will downshift to 25 [basis points], but I think there is a pretty high bar for that," Swift said.
Price up, GDP growth down
The personal consumption expenditures price index, the Fed's preferred measure of inflation, rose 6.3% from April 2021 to April 2022, down from 6.6% growth from the 12 months ending March 2022.
The PCE is based on surveys of what businesses are selling, while the CPI, the market's preferred inflation metric, is based on a survey of household purchases.
According to the Fed's quarterly summary of economic projections, released after the June 15 meeting, most Fed officials now see PCE inflation at 5.2% in 2022, well above the Fed's goal of 2%. In mid-2021 Fed officials forecast PCE inflation to be 2.1% in 2022.
"Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures," the Fed said in its June 15 statement, including the war in Ukraine and COVID-19 lockdowns in China. "The Committee is highly attentive to inflation risks."
Still, Fed officials believe the current surge in inflation will be short-lived. The latest median forecast foresees PCE inflation falling to 2.6% in 2023 and 2.2% in 2024.
Fed officials believe that aggressive rate hikes throughout this year will effectively tame inflation, said Patrick Leary, a senior trader with Loop Capital Markets. That could be a challenge, though, since monetary policy can only impact demand, not supply.
"The Fed is really stuck between a rock and a hard place here," said Leary, pointing out that the central bank is unable to impact the rising prices of food and energy. "If crude oil prices don't start to come down then inflation will not come down."
Market reactions
Soaring inflation and expectations of more rate hikes have caused the U.S. dollar to surge, equities to tumble and bond yields, which move counter to prices, to rise.
The S&P 500 officially entered a bear market, classified as a 20% fall from its high, this week. Ahead of Powell's press conference, the S&P 500 had fallen 22.1% from its Jan. 4 peak.
Treasury bond yields have also surged since the start of the year, particularly the 2-year yield, which climbed 272 basis points from Dec. 31, 2021, to June 14, 2022.