The Federal Reserve has recognized an important reality: Sometime soon, it might actually have to raise interest rates significantly to curb inflation. Officials are right to put themselves in a position to act if necessary, even if markets might not like it.
For most of this year, the Fed has predicated its monetary policy on projections that, in hindsight, contained an element of magical thinking. Officials expected inflation to remain within control even as they kept providing monetary stimulus to an economy running beyond capacity. As of September, the Fed’s median forecast assumed that annual consumer-price increases would subside to 2.1% by the end of 2024, while the unemployment rate would plunge to 3.5% and short-term interest rates would remain very low, reaching a mere 1.8%.
Economic developments have rendered that benign view untenable. Inflation has proved higher and more persistent than expected: In the three months through November, the core consumer price index, which excludes volatile food and energy prices, rose at an annualized rate of 5.6%, nearly triple the central bank’s objective of 2%. Over the same period, robust hiring pushed average hourly earnings up an annualized 4.8% — a welcome raise for workers, but a troubling sign for economists worried about a self-reinforcing wage-price spiral.
It’s good to see the Fed preparing to respond. By doubling the pace at which it will taper its monthly purchases of Treasury and mortgage securities, it has put the program on a trajectory to end much earlier — by March instead of June. This, in turn, will give officials the option of raising the Fed’s short-term interest-rate target from its current level of near-zero at their mid-March policy-making meeting, and beyond that to raise rates higher and sooner if inflation doesn’t subside. This possibility is at least partially recognized in the Fed’s longer-term projections: The median forecast for the target rate at the end of 2024 is 2.1%.
To be sure, the economic outlook remains highly uncertain. Developments such as the emergence of new Covid variants could yet undermine the recovery and require keeping interest rates low, something the Fed is fully capable of doing. What matters is that by ending the asset-purchase program sooner, the central bank leaves its options open. This is prudent risk management.
So far, markets have taken the Fed’s policy shift largely in stride. But there’s still a significant gap between the expectations of Fed officials and investors accustomed to accommodation. As of Wednesday afternoon, for example, prices in Eurodollar futures markets implied that short-term interest rates won’t exceed 1.8% over the next few years. At some point, coming to terms with the central bank’s plans might require a painful adjustment. So be it. The Fed’s responsibility is to the entire economy, not to markets alone.
