May 20, 2022
Federal Reserve official Loretta J. Mester

The Federal Reserve is on course for another series of interest rate hikes this year and next, though officials have signaled they expect to lower their holdings of mortgage-backed securities and Treasury bonds. Such moves raise the cost of credit, but Mester said that a faster pace of rate hikes is needed. She cited an expanding job market and a growing economy as reasons to be optimistic.

The US economy is currently growing and the rate of inflation is relatively low, especially compared to historical standards. However, a low unemployment rate is still producing large wage gains for many workers. President Biden has focused his remarks on the job market, pointing out that it is the best since World War II. Meanwhile, a booming job market is helping consumers.

Inflation is the rate at which prices rise over a year. The Fed’s goal is to keep the inflation rate at 2% or less. When inflation rises, consumers and businesses lose money. Inflation spikes, however, artificially raising prices. Inflation at more than 2%, however, causes consumers to spend now and avoid paying for them later.

While the Fed’s statement did not hint at slowing asset purchases or raising interest rates, the economy’s performance in the first quarter is another reason for investors to remain optimistic. This report is expected to show that the economy grew 6.5% in the first quarter, a figure most economists expect to be the strongest since 1984. Meanwhile, inflation has been on the rise since March. March consumer prices rose 2.6% year-over-year.

Rising energy prices are dampening household spending power. Energy spending accounts for less than a third of consumer spending and is a regressive tax on consumers. Moreover, the decline in the savings rate has lowered households’ buffer against inflation. Consequently, the Fed is unconcerned about inflation for now. It should not be surprising to see the US inflation rate climb higher than 2% through 2023.

The Federal Reserve should raise interest rates more aggressively than it did during the Great Recession. In Europe, inflation has exceeded expectations, and many watch the European Central Bank’s tightening sooner than previously predicted. In fact, it is rumored that the European Central Bank will begin tightening earlier than previously suggested. However, there is no evidence to back this up.

The Fed has the right tools to react to the Russian invasion of Ukraine. The war in the Ukraine has already caused swift market moves and ripple effects. These effects have impacted virtually every asset class. The ruptures in the commodity space are the latest discomfort for the markets. And if the Fed takes action, the market will move accordingly. The next step for investors will be to decide whether to raise interest rates aggressively or move cautiously.