The Fed raises interest rates by only a quarter-point after inflation drops

The Federal Reserve raised interest rates by a quarter percentage point Wednesday, its eighth increase in less than a year as the central bank continues its crackdown on inflation.

The hike in the Fed's benchmark rate is the smallest since last March, and signals that policymakers are shifting to a more cautious approach, after spending much of last year playing catch-up and boosting borrowing costs at the fastest pace in decades.

Higher interest rates have begun to have the desired effect. Consumer spending has cooled in recent months. And inflation had dropped significantly, although prices are still climbing faster than the central bank would like.

Excluding volatile food and energy costs, "core" prices in December were 4.4% higher than a year ago, according to the Fed's preferred inflation yardstick. That's down from a 5.2% annual rate in September.

Wage gains have also eased in recent months, despite the tight job market. That helps to allay concerns that rapid wage gains might put more upward pressure on prices — as happened in the 1970s.

The Fed wants no surprises on inflation

The gradual decline in both prices and wages is exactly what the Fed has been trying to achieve.

"This is what the path for a soft landing looks like," says Aaron Sojourner, an economist at the Upjohn Institute for Employment Research. "Inflation has come down but there's not a recession."

Fed policymakers are cautious, however, about declaring victory prematurely.

"Inflation has eased somewhat but remains elevated," the Fed's rate-setting committee said in a statement. "The Committee is strongly committed to returning inflation to its 2% objective."

"We do not want to be head-faked like we were in 2021," Fed governor Chris Waller said two weeks ago. "Back in 2021, we saw three consecutive months of relatively low readings of core inflation before it exploded in our face."

While the price of some goods — like new and used cars — has started to fall, the Fed is concerned that the price of labor-intensive services may continue to climb. That would make it harder to get inflation back down to the central bank's target of 2%.

Markets don't see eye to eye with the Fed

On average, Fed policymakers said in December they expect their benchmark interest rate to climb to 5.1% — from 4.625% now — and remain there at least through the end of the year.

Financial markets are skeptical of that forecast. Many investors are betting that the central bank will soon start cutting interest rates, despite repeated warnings to the contrary from Fed officials. The expectation of lower borrowing costs is one reason the stock and bond markets have rallied in recent weeks.

"The market has a very optimistic view that inflation is just going to melt away," Waller said. "We have a different view, that inflation is not just going to miraculously melt away. It's going to be a slower, harder slog to get inflation down. And therefore we have to keep rates higher for longer."

Will the Fed overdo the fight against inflation?

Two years ago, Fed policymakers believed that inflation would come down on its own, once pandemic supply problems were resolved. Instead, price hikes proved both larger and longer-lasting than the central bank expected.

Now, some analysts worry the Fed is in danger of making the opposite mistake, pushing interest rates higher and slowing the economy more than necessary to bring prices under control.

"We're pulling off something really nice right now," says Sojourner, who served as a senior economist for the Council of Economic Advisers in both the Obama and Trump administrations. "If the we get to the place where the Fed over-corrects, then we start to see jobs destroyed. Hopefully we can avoid that." [Copyright 2023 NPR]