The Fed expects to raise rates sooner than you’d think

The Federal Reserve expects to raise interest rates in 2023, according to new economic projections the central bank published Wednesday.

That’s a sharp contrast from the Fed’s previous forecast in March, in which the central bank predicted rates would stay near zero for at least the next two years.

Some members of the Federal Open Market Committee – which decides the central bank’s policy – are in favor of raising interest rates next year, the projections show.

The central bank also expects stronger growth, with real gross domestic product – the broadest measure of economic activity – climbing 7% in 2021, up from 6.5% in the March projections.

Rising inflation

But with stronger growth comes higher inflation. The Fed has upped its 2021 inflation forecast by a whole percentage point to a brisk 3.4%, reflecting the increases in prices across the spectrum for both consumers and producers.

That’s well above the Fed’s goal of around 2%. However, the central bank is still signaling confidence that this burst of inflation will pass. The median expectation is for inflation to ease to just 2.1% in 2022, up just slightly from the March projection. Forecasts for 2023 inflation barely budged higher. In its policy statement, the Fed again noted that “inflation has risen,” but stressed this “largely” reflects transitory factors.

Supply chain bottlenecks and shortages have driven inflation higher over the past several months. Companies are trying to keep up with demand, but Powell said it’s unlikely that this will lead to its opposite–excess supply.

“The problem now is that demand is very strong, incomes are high, people have money in the bank accounts. Demand for goods is extremely high, and it hasn’t come down,” Powell said. “But in terms of over-correcting, there is a possibility on the other side of this that inflation could actually be quite low going forward. But that is not where our focus is right now.”

Powell said there’s no reason to assume that prices will remain high for a long time. If prices keep soaring for travel, for example, people will likely build new hotels. But the timing of when prices come back to a normal range remains uncertain, he said.

“We don’t in any way dismiss the chance that it can work out that this goes on longer than expected, and the risk would be that over time, it does begin to affect inflation expectations,” Powell said.

If that is the case, the Fed would go back to its toolbox to address the issue, he said.

For now, the Fed will leave interest rates unchanged and continue its quantitative easing program, including buying at least $80 billion in Treasury securities and at least $40 billion in of mortgage-backed securities, according to its policy update Wednesday.

However, Fed Chairman Jerome Powell admitted that this week’s policy meeting was “‘the talking about talking about it’ meeting,” referring to a statement he made last year that the central bank wasn’t even discussing the eventual discussion to taper asset purchases.

Job market improvements

The Fed is definitely feeling better about the economy in the near term. But that’s not quite true for the labor market: The central bank’s unemployment rate expectations remained unchanged at 4.5% in its projections before dropping to 3.8% next year and 3.5% in 2023.

“We’re on path to a very strong labor market,” Powell said during Wednesday’s press conference.

But he also acknowledged that it was hard to tell what labor force participation might look like after the pandemic, which forced some workers to drop out of the workforce.

Stocks sink

US stocks fell in response to the news and ended the day in the red. The Dow (INDU) closed down 0.8% or 266 points, while the S&P 500 (SPX) and Nasdaq Composite (COMP) declined 0.5% and 0.2%, respectively.

Higher rates are potentially bad news for stocks down the road, as more expensive borrowing could eat into corporate bottom lines, ending the easy money policy of the past 15 months.

Stocks have been plodding along for the past several weeks in anticipation of Wednesday’s Fed update. Investors had grown more complacent, even as multiple inflation reports showed prices were rising more than expected, a big reversal from the initial worries about inflation.

Still, it would be good news for investors if the Fed largely stayed the course and kept rates near rock-bottom.

And that’s pretty much what the Fed did Wednesday: Rates remain ultra-low.