In what observers labelled as “dovish tightening”, the Federal Reserve on Wednesday evening raised interest rates for the first time since 2018 and flagged that six more rate hikes are coming later this year. Equity markets rallied but with an inverting yield curve, Treasuries reflect hesitation.
The US system of central banks raised its rates because it believes inflation is rising above its targets at a time when labour markets face shortages and the economy continues to expand. US policy makers flagged that further rate hikes will follow in all of its subsequent meetings this year, bringing its main interest rate to 2 percent by the end of this year.
The Fed raised the target for federal funds rate by 25 basis points to between 0.25 percent and 0.50 percent. It also said that it will begin reducing its holdings of Treasury securities and mortgage-backed securities at its next meeting.
The Fed’s determination initially shook markets, with equity indices falling but then recovering these losses during Jerome Powell’s press conference and ending higher when it ended. “We expect inflation to remain high through the middle of the year,” said Powell.
Yield curve inverting
Debt markets were less enthusiastic about Powell’s upbeat outlook, as made clear by an inversion of the Treasury yield curve. On Wednesday evening, the difference between yields on 5-year Treasuries and 10-year Treasuries inverted for the first time since March 2020, reported Bloomberg, suggesting that markets expect more growth pains to come.
In early trading on Wednesday, the 5-year/10-year Treasury spread turned below zero for the first time since 2007.
In its statement, the Federal Reserve’s policy-setting open market committee, known as FOMC, said indicators of economic activity and employment have continued to strengthen. Job gains have been strong in recent months, and the unemployment rate has declined substantially. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.
Ukraine invasion adds uncertainty
“The invasion of Ukraine by Russia is causing tremendous human and economic hardship. The implications for the U.S. economy are highly uncertain, but in the near term the invasion and related events are likely to create additional upward pressure on inflation and weigh on economic activity,” the FOMC said.
The Fed said it seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. With appropriate firming in the stance of monetary policy, the Committee expects inflation to return to its 2 percent objective and the labour market to remain strong.