Fed slows rate hike to 0.5%, but signals higher peak rate ahead

© Reuters

By Yasin Ebrahim

AiVIF.com -- The Federal Reserve raised interest rates by 0.5% on Wednesday, and laid out the carpet for a slower pace of hikes ahead, but signaled that rates will have to move higher than previously projected as inflation remains well above target.

The Federal Open Market Committee, the FOMC, raised its benchmark rate to a range of 4.25% to 4.5% from 3.75% to 4% previously. 

The move marked a slowdown from the 0.75% rate increases seen at the prior four meetings. This steep pace of rate hikes, the fastest since the 1980s, has begun to make a dent in inflation.

While the recent evidence pointing to slowing inflation has been encouraging, the Fed believes further hikes, though at a slower pace, are needed to ensure that price pressures eventually drop to its 2% target.

The Fed now sees its benchmark rate rising to a peak, or terminal rate, of 5.1% in 2023, above the 4.6% forecast in September, suggesting at least two 25 basis point rate hikes ahead.

That is slightly higher than market expectations for rates to peak at the high end of around 5%.

The central bank also signaled that its likely to keep rates higher for longer through 2023, disappointing market participants calling for a cut in the second half of next year. The Fed forecasts a cut in 2024 to 4.1%, above the 3.9% projected previously.

Last month, Fed Chairman Jerome Powell flagged the strong price pressures in the services sector, ex-housing, of the economy, underpinned by wage growth, as a key driver of inflation and reiterated that there is still more work to do.

"Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category," Powell said in a November speech at the Brookings Institution event in Washington.

The core personal consumption expenditures price index, the Fed’s preferred measure of inflation, is forecast to climb to 3.5% in 2023, up from a prior forecast of 3.1%. For 2024, inflation is estimated to slow to 2.5%, compared with the prior forecast of 2.3%. Fed members kept their inflation forecasts for 2025 unchanged at 2.1%.

The Fed believes its higher for longer rate regime will slow demand in the labor market more than previously forecast, helping to bring wage growth under control. Unemployment expected to reach 4.6% in 2023 and remain unchanged the following year, according to the Fed's projections. That is above the prior September forecast of 4.4%.

Acknowledging the impact of tighter monetary policy, the Fed members cut their growth forecast for 2023 by more than half to 0.5% from 1.2% previously. Growth in 2024 and 2025 is expected to be 1.6%, down from a prior projection of 1.7%.

As the Fed readies a slower path of rate hikes ahead, investors remain wary of the risk that the central bank tightens too much and argue for a pause sooner rather than later as the rate hikes delivered so far need time to fully impact the economy.

“Signs that inflation is easing allows the Fed to take a breath, and let their incredibly powerful policy proliferate through the economy,” Diton said ahead of the decision. “I think they've done enough … they don’t need to do anything other than just wait."