Federal Reserve officials appear poised to finish the most inflationary year since the 1980s on an optimistic note: They are expected to slow their campaign to cool the economy at their meeting on Wednesday, just as incoming data offer reasons to hope that price increases will fade next year.
Central bankers are expected to lift interest rates by half a percentage point to a range of 4.25 to 4.5 percent. That would be a slowdown from their past four meetings, where they raised rates in three-quarter-point increments.
Officials will also release a fresh set of economic projections, their first since September, which will offer a glimpse at how high they expect rates to rise in 2023 and how long they plan to hold them there.
Fed policymakers have lifted borrowing costs at the fastest pace in decades this year to slow demand in the economy, hoping to tamp down inflationary pressures and prevent rapid increases from becoming a permanent feature of the American economy. While inflation is now showing signs of slowing, it remains much faster than usual, and central bankers have made clear that they have more work to do in ensuring that it returns to normal.
But policy changes take time to fully play out, and the Fed wants to avoid accidentally squeezing demand so much that the economy contracts more than is necessary to wrangle inflation. That is why officials are moving away from super-rapid price increases and into a new phase where they focus on how high interest rates will rise and, perhaps even more critically, how long they will stay elevated.
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
What causes inflation? It can be the result of rising consumer demand. But inflation can also rise and fall based on developments that have little to do with economic conditions, such as limited oil production and supply chain problems.
Is inflation bad? It depends on the circumstances. Fast price increases spell trouble, but moderate price gains can lead to higher wages and job growth.
How does inflation affect the poor? Inflation can be especially hard to shoulder for poor households because they spend a bigger chunk of their budgets on necessities like food, housing and gas.
Can inflation affect the stock market? Rapid inflation typically spells trouble for stocks. Financial assets in general have historically fared badly during inflation booms, while tangible assets like houses have held their value better.
“How fast has been answered, and how high seems to be coming into sight — how long is the unknown,” said Michael Gapen, chief U.S. economist at Bank of America. “If we want to get inflation down to 2 percent, we still have to remove some labor market tightness.”
The Fed targets 2 percent inflation on an annual basis, but price increases were running at about three times that pace in the year through October, based on the central bank’s preferred index. A more timely inflation measure released on Tuesday, the Consumer Price Index, suggested that inflation slowed notably in November — which should give officials some reason for confidence.
But price increases for service categories, including dental care and sports games, remain rapid. At least one major driver of services inflation — rent — is likely to moderate in 2023. But for other service categories, rapid wage growth could make it difficult for inflationary pressures to cool completely.
Services outside of housing “may be the most important category for understanding the future evolution of core inflation,” Jerome H. Powell, the Fed chair, said during a recent speech. “Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”
Average hourly earnings are now climbing 5.1 percent on a yearly basis, which is notably faster than the roughly 3 percent annual gains that prevailed before the pandemic. As companies pay their workforces more, they are likely to try to charge their customers more to cover their climbing labor bills.
The Fed’s last set of economic projections predicted that rates would rise to 4.6 percent in 2023. Officials have suggested that they might climb slightly higher than that in the new set of projections, partly because the labor market has been more resilient and inflation more stubborn than many had expected.
Investors will closely parse the new release for any hint at how high rates will climb next year. On Tuesday, they were betting that the Fed would stop lifting rates once they hit a range of 4.75 to 5 percent next year — suggesting that central bankers would make two more quarter-point increases following this week’s move.
But Wall Street will be equally if not more focused on what Mr. Powell says about the central bank’s plans for after rate moves stop. Mr. Powell will deliver a news conference at 2:30 p.m.
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Fed officials have conveyed that they plan to hold rates at a high level for some time to snuff out inflation once and for all. But market pricing suggests that investors expect them to begin cutting rates as early as the second half of next year — a seeming disconnect that will put focus squarely on the Fed chair’s comments on Wednesday.
Policymakers have said that they do not want to overdo their policy response, but that the more serious error would be allowing inflation to become entrenched in the economy.
If price increases were to continue eroding American paychecks for years on end, they could begin to feed on themselves, with consumers asking for bigger raises and companies instituting bigger price adjustments to cover rising input and labor bills. That sort of self-fulfilling cycle is exactly what the Fed is trying to avoid.
In the 1970s, officials allowed inflation to remain slightly more rapid than usual for years on end, which created what economists have since called an “inflationary psychology.” When oil prices spiked for geopolitical reasons, an already elevated inflation base and high inflation expectations helped price increases to climb drastically. Fed policymakers ultimately raised rates to nearly 20 percent and pushed unemployment to double digits to bring prices back under control.
Central bankers today want to avoid a rerun of that painful experience. That’s why they have signaled that they do not want to give up on their fight against inflation too early.
“We will stay the course until the job is done,” Mr. Powell said in a speech late last month.