WASHINGTON — With inflation surging and unemployment falling, the Federal Reserve said Wednesday that it will shrink its support for the economy more quickly and expects to raise interest rates three times next year.
Fed Chair Jerome Powell said the U.S. economy is growing at a “robust pace” even as it faces risks from the pandemic, and he thinks spending by businesses and consumers will remain strong. But because inflation is likely to persist longer than the Fed had earlier expected, Powell said the central bank needs to address that threat to help the economy sustain its expansion.
“We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched,” Powell said at a news conference.
In a sharp policy shift, the Fed said it will withdraw its monthly bond purchases at twice the pace it previously announced and likely end them in March. The accelerated timetable puts the Fed on a path to start raising rates as early as the first half of next year.
The Fed’s new forecast that it will raise its benchmark short-term rate three times next year is up from just one rate hike it had projected in September. The Fed’s key rate, now pinned near zero, influences many consumer and business loans, including for mortgages, credit cards and auto loans.
Those borrowing costs may start to rise in the coming months, though the Fed’s actions don’t always immediately affect other loan rates. And even if the central bank does raise rates three times next year, it would still leave its benchmark rate historically low, below 1%.
The policy change reflects Fed policymakers’ acknowledgement that with inflation pressures rising, the Fed needed to begin tightening credit for consumers and businesses faster than they had expected just a few weeks earlier. The Fed had earlier characterized the inflation spike as mainly a “transitory” problem that would fade as supply bottlenecks caused by the pandemic were resolved. The shift was signaled in testimony that Powell gave to Congress two weeks ago.
The run-up in prices has persisted longer than the Fed expected and has spread from goods like food, energy and autos to services like apartment rents, restaurant meals and hotel rooms. It has weighed heavily on consumers, especially lower-income households and particularly for everyday necessities, and negated the higher wages many workers have received.
Powell was asked at his news conference Wednesday what specifically had caused the Fed to pivot to a tighter credit policy.
“It was essentially higher inflation and much faster progress in the labor market,” he said.
He acknowledged the possibility that inflation won’t decline as expected next year.
“There’s a real risk now,” Powell said, “that inflation may be more persistent and that may be putting inflation expectations under pressure, and that the risk of higher inflation becoming entrenched has increased. I think part of the reason behind our move today is to put ourselves in a position to be able to deal with that risk.”
Collectively, the Fed’s policymakers forecast Wednesday that inflation, as measured by their preferred gauge, will reach 5.3% by year’s end, up from their October reading of 5%. They expect inflation to slow considerably to a 2.6% annual rate by the end of 2022. But that’s up from its September forecast of just 2.2%.
The officials foresee the unemployment rate falling to 3.5% by the end of next year, which would match the pre-pandemic level, when unemployment was at 50-year lows.
The Fed is buying $90 billion a month in bonds, down from $120 billion in October, and had been reducing those purchases by $15 billion a month. But in January, it will reduce those purchases by $30 billion, to $60 billion, and will be on track, Powell said, to end them altogether in March. The bond buying has been intended to lower long-term interest rates and encourage more borrowing and spending.
The Fed is shifting its attention away from reducing unemployment, which has fallen quickly to a healthy 4.2%, down from 4.8% at its last meeting, and toward reining in higher prices. Consumer prices soared 6.8% in November compared with a year earlier, the government said last week, the fastest pace in nearly four decades.
On Wall Street, stock prices rose gradually and then surged after the Fed issued its statement, and Powell began speaking at a news conference. By the time Powell finished, the Dow Jones Industrial Average had jumped more than 300 points.
The Fed’s policy change does carry risks. Raising borrowing costs too fast could stifle consumer and business spending. That, in turn, would weaken the economy and likely raise unemployment.
Yet if the Fed waits too long to raise rates, inflation could surge out of control. It might then have to act aggressively to tighten credit and potentially trigger another recession.
Fed officials have said they expect inflation to cool by the second half of next year. Gas prices have already come off their peaks. Supply chain bottlenecks in some areas are gradually easing. And government stimulus payments, which helped spur a spike in spending that boosted inflation, aren’t likely to return.
Yet many economists expect high prices to persist. That likelihood was reinforced this week by a government report that wholesale inflation jumped 9.6% for the 12 months ending in November, the fastest year-over-year pace on records dating to 2010.
Housing costs, including apartment rents and the cost of homeownership, which make up about one-third of the consumer price index, have been rising at a 5% annual pace the past few months, economists at Goldman Sachs have calculated. Restaurant prices jumped 5.8% in November from a year ago, a nearly four-decade high, partly reflecting higher wage costs. Such increases will likely keep inflation well above the Fed’s 2% annual target next year.
At his news conference, Powell noted that consumers — the leading driver of the economy — remain on solid footing.
“Fundamentally,” he said, “the consumer is really healthy, and we expect personal consumption expenditures to be pretty strong” in the current fourth quarter of the year.
AP Economics Writer Martin Crutsinger contributed to this report.
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