The Federal Reserve is planning to increase interest rates more slowly and cautiously in 2023 compared to last year. After raising interest rates at a pace that was not seen since the 1980s in 2022, officials are taking a more deliberate approach. In March 2023, the Fed increased interest rates by a quarter of a percentage point, bringing the benchmark borrowing rate to a new target range of 4.75-5 percent. However, this was not without challenges, as two major bank failures in March rocked financial markets, creating concerns about stability and the potential to throw the economy off course.
Although officials at the Fed are projecting further rate increases, they are acknowledging that there is some uncertainty. Only one policymaker does not see any rate hikes this year, whereas ten see just one more. Three officials project two more rate hikes, another three project three more, and one projects four more.
Higher interest rates are part of the solution to rising inflation, which rose by 6 percent in February compared to the previous year. This figure has declined by over 3 percentage points from its peak of 9.1 percent in June 2022, but it remains three times the Fed's preferred target of 2 percent inflation. Furthermore, inflation has not slowed as much as officials expected, leading policymakers to upgrade their inflation forecasts for the year in March.
The recent banking stress highlights the need for the Fed to manage both financial and price stability. However, the full extent of the effect on the economy is uncertain. Financial conditions have tightened since the March bank failures, with stock markets experiencing some volatility, particularly for banks. Additionally, difficulties in trading the most liquid assets in the bond market could lead to banks slowing lending to businesses and consumers to ensure that they have enough cash to meet depositors' needs. Less lending and difficulties in securing credit could reduce demand, which could help to cool inflation.
If the financial system remains stable, further rate hikes are likely. However, if another crisis occurs and conditions deteriorate, the Fed may need to reverse course and begin cutting rates aggressively. Market participants are not confident that the Fed will be able to lift rates further. CME Group's FedWatch indicates that traders expect the Fed's benchmark rate to remain in its target range of 4.75-5 percent until the autumn when the Fed may need to cut borrowing costs. Traders expect 50 basis points of cuts by the end of the year.
Fed officials do not expect to slash interest rates until 2024. In March, they suggested that they see just 75 basis points worth of cuts, rather than the previously projected 100 basis points. They view inflation as staying above the Fed's 2 percent target through 2025. Although the U.S. economy is expected to grow modestly over the next two years, the largest majority of Fed officials sees the risks to both core and headline inflation as weighted to the upside.
