Author: smarttalksucce

The Federal Reserve is poised to announce its first interest rate hike since 2018 on Wednesday.

The central bank is likely to raise its target federal funds rate by 25 basis points to address the worst inflation in more than 40 years, partially brought on by the coronavirus pandemic. A basis point is equal to 0.01%.

Yet consumers who are already grappling with higher prices putting a strain on their wallets may be wondering how increasing borrowing costs will help tamp down inflation.

The consumer price index soared to a 7.9% annual rate in February, the highest level since January 1982. Rising costs of items such as food and fuel drove the increase and further eroded any wage gains that workers may have seen in the last year.

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“This is something really hard for the typical consumer to understand, seeing these fast price raises that are so unfamiliar to large parts of our population who haven’t seen inflation rates like this before,” said Tara Sinclair, a senior fellow at the Indeed Hiring Lab. “And then trying to figure out the Fed’s complicated role in all of this is very confusing.”

Here’s what you need to know.

The Fed’s mandate

The Federal Reserve has a few main goals with respect to the economy: to promote maximum employment, keep prices stable and ensure moderate long-term interest rates.

Generally, the central bank aims to keep inflation around 2% annually, a number that lagged before the pandemic.

Its main tool to battle inflation is interest rates. It does that by setting the short-term borrowing rate for commercial banks, and then those banks pass rates along to consumers and businesses, said Yiming Ma, an assistant finance professor at Columbia University Business School.

That higher rate influences the interest you pay on everything from credit cards to mortgages to car loans, making borrowing more expensive. On the flip side, it also boosts rates on savings accounts.

Interest rates and the economy

But how do higher interest rates reel in inflation? They help by slowing down the economy, according to the experts.

“The Fed uses interest rates as either a gas pedal or a brake on the economy when needed,” said Greg McBride, chief financial analyst at Bankrate. “With inflation running high, they can raise interest rates and use that to pump the brakes on the economy in an effort to get inflation under control.”  

Basically, the Fed policymakers aim to make borrowing more expensive so that consumers and businesses hold off on making any investments, thereby cooling off demand and hopefully holding down prices.

There could also be a secondary effect of alleviating supply chain issues, one of the main reasons that prices are spiking right now, said McBride. Still, the central back can’t directly influence or solve that particular problem, he said.

“As long as the supply chain is an issue, we’re likely to be contending with outside wage gains,” which drive inflation, he said.

What the Fed wants to avoid

The main worry for economists is that the Fed raises interest rates too quickly and dampens demand too much, stalling the economy.

This could lead to higher unemployment if businesses stop hiring or even lay off workers. If policymakers really overshoot on rate hikes, it could push the economy into a recession, halting and reversing the progress it has made so far.

Treating inflation in the economy is like treating cancer with chemotherapy, said Sinclair of the Indeed Hiring Lab.

“You have to kill parts of the economy to slow things down,” she said. “It’s not a pleasant treatment.”

Of course, it will take some time for any action to affect the economy and curb inflation. That’s why the Federal Open Market Committee carefully watches economic data to decide how much and how frequently to raise rates.

There is also some uncertainty due to the war in Ukraine, which has also increased prices on commodities such as gas. The Fed will have to watch how the war is hampering the U.S. economy and act accordingly.

It might get worse before it gets better

When the Fed does lift rates, it’s also likely that people will see the downsides of those increases before any improvement on inflation, said Sinclair.

Basically, that means consumers may have to pay more to borrow money and still see higher prices at the gas pump and grocery store. That scenario is particularly tough on low-income workers, who have seen wages rise but not keep pace with inflation.

Of course, ideally the central bank would like to raise rates gradually so that the economy slows just enough to bring down prices without creating too much additional unemployment.

“They have to carefully walk that tightrope,” said Sinclair.

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Forecasters have raised their outlooks for a recession and boosted their inflation projection as the Federal Reserve faces the quandary of fast-rising prices and greater uncertainty from Russia’s invasion of Ukraine, according to the latest CNBC Fed Survey.

The probability of a recession in the U.S. was raised to 33% in the next 12 months, up 10 percentage points from the Feb. 1 survey. The chance of a recession in Europe stands at 50%.

Respondents debated whether the recent surge in commodity prices would prompt the Fed to hike rates faster because it adds to inflation or raise rates less because they reduce growth.

“The tax impact of higher commodities prices is likely to slow the pace of hiking more than the inflationary impact is to accelerate it,” wrote Guy LeBas, chief fixed income strategist at Janney Montgomery Scott.

But Rob Morgan, senior vice president at Mosaic, wrote: “I expect six quarter-point rate hikes from the Fed in 2022. If CPI reaches 9% in the March or April report, the Fed might be pressured into a 50-basis point hike in May.”

The 33 respondents, who include fund managers, strategists and economists, forecast the Fed will raise rates an average of 4.7 times this year, bringing the funds rate to end the year at 1.4% and to 2% by the end of 2023. Nearly half of the respondents see the central bank hiking five to seven times this year.

The rate hike cycle is seen ending at a peak funds rate of 2.4%, about the Fed’s neutral rate. But half of all respondents believe the central bank may ultimately have to raise rates above neutral to get control of inflation.

Propelling the rate increases are forecasts for the consumer price index to peak at 8.5% in March, but gradually decline to finish the year at a still high 5.2%. That’s nearly a full percentage point higher than the February survey. The CPI in 2023 is forecast to rise a tamer 3.3%, a rate still above the Fed’s target.

“We might be on the cusp of the Fed raising rates at the same time there is a minus sign in front of GDP,” wrote Peter Boockvar, chief investment officer of Bleakley Advisory Group. “What an awful position to be in, but until inflation falls sharply, they have no choice but to carry on.”

While a recession is seen as a greater possibility than in February, it’s not the base case for most respondents. The average GDP forecast for this year slipped by 0.8 percentage point but remains at a slightly above-trend 2.8%. The GDP forecast for 2023 dropped by about a half a point from the last survey to 2.4%.

Inflation forecasts had already been high for this year, but Russia’s invasion of Ukraine has aggravated the situation with nearly 90% saying they boosted their 2022 inflation outlook because of the war. They added an average 0.8 percentage point to their inflation forecast. Sixty percent of respondents said they shaved the GDP forecasts due to the conflict, with an average of a half a point.

While inflation forecasts rose and growth outlooks declined, the outlook for stocks is relatively bullish. Respondents lowered their outlook for equities, but only 53% now say stocks are overvalued relative to the outlook for earnings and growth. That’s down from 88% a year ago, and the least bearish respondents have been since the Covid pandemic began.

Meanwhile, the CNBC Risk/Reward ratio (measuring the chance of a 10% correction verus the chance of a 10% increase in the next six months) improved to -9 from -14, meaning a negative correction is judged less likely. The outlook for the S&P 500 dropped to 4,431 this year, suggesting stocks could have 6% upside from the current level.

Another surge in energy prices pushed wholesale goods prices to their biggest one-month jump on record in February, according to Labor Department data released Tuesday.

Final demand prices for goods jumped 2.4% for the month, the largest move ever in data going back to December 2009, the Bureau of Labor Statistics said.

That pushed the headline producer price index up 0.8% on the month, which actually was slightly lower than the 0.9% Dow Jones estimate.

Excluding food, energy and trade services, so-called core PPI rose just 0.2%, well below the 0.6% expectation.

On a year-over-year basis, headline PPI rose 10%, the same as January and tied for the biggest 12-month move ever.

The data came during the week of Feb. 13, before the Russian invasion of Ukraine. Energy prices surged even more as the war began, and will show up in next month’s report.

The numbers coincide with most other inflation gauges running around 40-year highs, thanks to price increases that have spread beyond volatile gas and grocery prices and across a broad spectrum of consumer goods and services.

In response to the inflation trend, the Federal Reserve is expected on Wednesday to raise interest rates for the first time since December 2018.

“Producer prices are an early warning sign of what households can expect in terms of consumer price inflation,” wrote PNC economist Kurt Rankin. “The message is clear that consumer prices have several months of exceptional gains ahead of them still, despite the fact that the Fed is set to begin hiking its policy rate in March and continue to do so throughout the year.”

Gasoline was still the main story in February when it came to final demand prices.

Some 40% of the increase in wholesale goods prices came from gasoline, which rose 14.8%. Diesel fuel and electric power also helped feed an 8.2% increase in final demand energy prices, while motor vehicles and equipment and dairy prices also climbed. Various prices for food products, such as fresh and dry vegetables along with beef and veal showed declines.

The PPI is not as closely watched as the consumer price index, but wholesale costs feed into prices at the register and are seen as a harbinger of inflation.