Federal Reserve officials voted Wednesday to raise their interest rate target for the second time in 2017 and to begin shrinking the central bank’s balance sheet this year, a vote of confidence in the prospects for the U.S. economy in the months ahead despite weak first-quarter growth and slowing inflation.
The rate increase brings the Fed’s target for short-term interest rates to a range of 1 percent to 1.25 percent, back to its level during the financial crisis in 2008, before the Ben Bernanke-led Fed lowered rates all the way to zero.
Fed officials also projected one more interest rate increase for this year.
By raising overnight rates, the Fed aims to influence interest rates on business loans, auto loans, mortgages, credit cards and all other forms of credit, in an effort to control total spending.
Shrinking the Fed’s balance sheet would have the same effect, and reverse the major bond-buying programs, or quantitative easing, that the Fed carried out during the recession.
The Fed said it would begin reducing its balance sheet at an unspecified point, likely later this year. When it starts doing so, it will decrease its holdings of Treasury and mortgage-backed securities by $10 billion a month by no longer reinvesting that amount of proceeds from the maturation of existing bonds. Over time, that $10 billion would rise to $50 billion, accelerating the run-off.
“This will just be something that runs quietly in the background,” Chairwoman Janet Yellen said of the balance sheet reduction plan, stating that interest rates would continue to be the Fed’s main tool.
The committee acknowledged that inflation has slowed, but only one member voted against the decision to continue tightening monetary policy anyway: Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, who has argued that the Fed should delay rate hikes until greater evidence that inflation will rise.
The Fed gained confidence in its plans for raising rates from the decline in unemployment that has taken place this year. At 4.3 percent in May, the unemployment rate is below the level that Fed officials earlier in the year projected it could go without eventually leading to too-high inflation.
Wednesday’s decision “reflects the progress the economy has made and is expected to make,” Yellen said at a press conference following the announcement.
Because the labor market appears to be close to running hot, Fed officials have indicated in recent months that they are reluctant to keep emergency-era policies much longer. Those extraordinary measures include both the ultra-low interest rates and the expanded $4.5 trillion balance sheet.
In a speech delivered in Singapore last month, Federal Reserve Bank of San Francisco President John Williams said that the Fed should aim for a “‘Goldilocks economy’ – an economy that doesn’t run too hot or too cold.”
The Fed is moving toward tighter monetary policy even though economic growth and inflation have defied its expectations in recent months.
Economic output grew at a weak 1.2 percent annual rate in the first quarter, according to the Bureau of Economic Analysis.
And inflation has been trending down. After running below the Fed’s 2 percent target since spring 2012, annual inflation finally hit 2.15 percent in February. Since then, however, it has dropped, hitting 1.7 percent in April. The consumer price index, a different index than the one preferred by the Fed, showed Wednesday morning as Fed officials met in Washington that price increases declined further in May.
Yet Fed officials have mostly shrugged off those developments as likely to be temporary. They, with the private sector, believe that growth will pick up in the second quarter. And there are signs that the slowdown in inflation is due to one-time factors, such as intense competition among cell service providers over unlimited data plans, which has sent phone prices crashing down. Wednesday’s statement predicted that inflation would “stabilize” around 2 percent after the near term.
Given that they expect the weak inflation and growth to be transitory, Fed officials are more wary about the economy running too “hot” and driving up inflation.
In fact, the Fed now sees a kind of golden age in store for the U.S. economy in the next few years. Officials projected that unemployment would fall to 4.2 percent and remain there through 2019, while inflation rises just to 2 percent and no higher.
