U.S. Fed signals more rate hikes to come after expected quarter-point increase

The U.S. Federal Reserve increased its benchmark interest rate by a quarter percentage point on Wednesday and signalled that a “couple” more rate hikes are still needed to bring inflation under control.

The widely anticipated announcement lifted the federal funds rate to a range of 4.5 per cent to 4.75 per cent. The quarter-point move is the smallest increase since the central bank began ratcheting up borrowing costs last spring in an effort to curb surging prices.

After a string of oversized rate hikes, the U.S. economy has begun to slow and inflation is showing signs of easing. Fed chair Jerome Powell said on Wednesday that “the disinflationary process has started,” although he warned that it would be “very premature to declare victory.”

“While recent developments are encouraging, we will need substantially more evidence to be confident that inflation is on a sustained downward path,” he said in a news conference after the rate announcement.

While the Fed was unambiguous that “ongoing increases” in borrowing costs are still necessary, financial markets responded positively to Mr. Powell’s relatively optimistic comments about inflation and the U.S. economy.

The S&P 500 finished the trading day up 1.05 per cent, while the Nasdaq Composite surged 2 per cent. Bond markets also rallied, with the yield on two-year U.S. government bonds falling around 0.1 per cent. Bond prices and yields move in opposite directions.

“While previous statements said the Fed would have to determine the pace of future rate rises, today’s statement indicated it will now have to determine their extent,” Desjardins economist Francis Généreux wrote in a note to clients. “Rate hikes aren’t over, but it may be the beginning of the end.”

Members of the Federal Open Market Committee, the Fed’s highest decisionmaking body, which sets U.S. monetary policy, signalled in December that they expect the fed funds rate to exceed 5 per cent by the end of the year. That would imply at least two more quarter-point hikes.

Mr. Powell reiterated this forecast, although he said future rate hikes would be conditional on incoming economic data. He also pushed back against market expectations that the Fed could start cutting interest rates this year.

Interest-rate-swap contracts are pricing at least two rate cuts before the end of 2023.

“The historical record cautions strongly against prematurely loosening policy. We will stay the course, until the job is done,” Mr. Powell said.

The Fed’s insistence that more rate hikes are still needed puts it on a different trajectory than the Bank of Canada.

Last week, Canada’s central bank increased its benchmark rate to 4.5 per cent, but said it expects to hold off further rate hikes. This “conditional pause” suggests that Canadian rates have reached a plateau while U.S. rates will keep marching higher.

The Canadian economy is generally seen as being more sensitive to interest rates than the U.S. economy, given how much of the Canadian economy relies on the housing sector. Canadian mortgages also tend to have five-year terms, compared with 30-year terms in the United States, making homeowners more susceptible to rate increases.

What happens next to U.S. interest rates will depend on the trajectory of inflation as well as the strength of the country’s labour market.

There are plenty of signs that inflation is trending in the right direction. The annual rate of consumer price index inflation in the U.S. was 6.5 per cent in December, down from a 40-year high of 9.1 per cent in June.

Prices for many goods, such as used vehicles, have fallen in recent months, as supply chains have improved and consumer demand has shifted back toward services. Mr. Powell said he also expects housing-related inflation to diminish in the coming months.

The challenge is service prices, excluding housing, which show few signs of decelerating. This is tied in part to rapid wage growth, which is being driven by the ultralow levels of unemployment, which stood at a record low 3.5 per cent in December.

Mr. Powell said unemployment will likely need to rise to slow the pace of service price growth. He expects this to happen in the coming quarters as higher rates work to slow the economy. Although, he suggested that a soft landing was still possible.

“There’s a path to getting inflation back down to 2 per cent without a really significant economic decline or a significant increase in unemployment,” he said.

The European Central Bank and the Bank of England will announce their latest interest-rate decisions on Thursday. The central banks are behind the Bank of Canada and the Fed when it comes to tightening monetary policy, and both are expected to announce further half-point rate increases.