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The Federal Reserve is about to deliver its biggest punch yet in the fight against surging inflation.
Policymakers start a two-day meeting on Tuesday, and they are widely expected to raise interest rates by half a percentage point – the largest rate hike in more than two decades.
It’s a clear sign of the urgency with which the Fed is approaching inflation, as prices continue to climb at the fastest pace in 40 years.
And the Fed will not be done there. The central bank is likely to keep pushing borrowing costs higher in the months to come.
Here’s a quick look at the Fed’s battle plan.
Why is the Fed raising interest rates?
The central bank is worried that prices are climbing too rapidly as people continue to spend money, from shopping for stuff to booking long-delayed vacations.
Demand is so strong it’s outpacing what businesses can deliver, given that global supply chains are still fragile and employers are still struggling to find enough workers.
A key measure from the Commerce Department last week showed prices had surged 6.6% during the 12 months ending in March. That’s more than three times the Fed’s target rate for inflation and the sharpest increase in prices since 1982.
The Fed hopes to tamp down demand and ease inflation by making it more expensive to borrow money.
The Fed raised interest rates by a quarter of a percentage point in March, and it’s expected to follow up this week with its first half-point rate hike since 2000.
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How much will the Fed raise interest rates?
Potentially a lot more.
Experts say interest rates may have to climb significantly to reduce demand after the Fed kept borrowing costs at rock-bottom levels through much of the coronavirus pandemic.
On average, Fed policymakers said at their March meeting, rates would need to rise nearly 2 full percentage points this year, with additional rate increases next year.
Fed Chair Jerome Powell said the central bank will keep a close eye on how the economy performs and adjust the pace of rate hikes as needed.
But Powell thinks the Fed’s usual practice of raising rates a quarter-point at a time may not be enough. He suggests the central bank needs to move aggressively upfront and then reassess as needed.
“It is appropriate in my view to be moving a little more quickly,” Powell told an International Monetary Fund forum last month. “I also think there’s something in the idea of front-end loading whatever accommodation one thinks is appropriate.”
How will raising borrowing costs affect the economy?
Rising interest rates make it more expensive to take out a car loan or carry a balance on a credit card.
They also raise the cost of buying a home. Mortgage rates have already soared above 5% in anticipation of the Fed’s actions, up from less than 3% a year ago. That adds about $ 370 to the monthly payment on a median-priced house.
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The Fed’s intent in raising rates is to discourage spending just enough to bring down inflation, without tipping the economy into recession – what economists call a “soft landing.”
“That’s our goal,” Powell said. “I do not think you’ll hear anyone at the Fed say that that’s going to be straightforward or easy.”
Some analysts are skeptical that the central bank can strike that delicate balance, having waited until inflation has climbed so high.
They warn the kind of aggressive action that’s now needed to control prices is likely to trigger an economic downturn. Deutsche Bank, a German lender and major Wall Street firm, last week forecast a “major recession” next year.
Those concerns contributed to last week’s sharp sell-off in the stock market.
What other steps is the Fed taking?
In addition to raising interest rates, the Fed is expected to announce plans to gradually reduce the collection of government bonds and mortgage-backed securities that it bought during the pandemic.
Buying those bonds helped pump money into the economy and keep borrowing costs low. Reducing the Fed’s holdings should have the opposite effect – tamping down demand and helping to curb inflation.
“It’s a secondary tool, but it does remove quite a bit of liquidity and accommodation from the system,” said Kathy Bostjancic of Oxford Economics.