Fed's Powell backs quarter point March rate hike; open to bigger moves later

2/2 © Reuters. FILE PHOTO: Federal Reserve Chair Jerome Powell testifies during a U.S. House Oversight and Reform Select Subcommittee hearing on coronavirus crisis, on Capitol Hill in Washington, U.S., June 22, 2021. Graeme Jennings/Pool via REUTERS 2/2

By Howard Schneider and Lindsay (NYSE:LNN) Dunsmuir

WASHINGTON (Reuters) -Federal Reserve Chair Jerome Powell, balancing high U.S. inflation against the complex new risks of a European land war, said Wednesday the central bank would begin “carefully” raising interest rates at its upcoming March meeting but be ready to move more aggressively if inflation does not cool as quickly as expected.

Powell called the Russian invasion of Ukraine "a game changer" that could have unpredictable consequences.

"There are events yet to come and we don't know what the real effect on the U.S. economy will be," Powell told the House Financial Services Committee during a monetary policy hearing overshadowed by the conflict in Europe.

But he said for now the Fed was proceeding largely as planned to raise the target overnight federal funds rate and reduce the size of its balance sheet in order to tame inflation that is currently the highest it has been since the 1980s.

Powell said he will back a quarter point rate increase when the Fed meets March 15-16, effectively putting to rest debate over starting a post-pandemic round of rate hikes with a larger than usual half-point increase.

But the Fed chief said he was ready if needed to use larger or more frequent rate moves if inflation does not slow, and may over time need to push rates to restrictive levels above 2.5% - slowing economic growth rather than simply stimulating it less robustly.

It is a subtle distinction but a marker of Powell’s focus on inflation as the key fight before the Fed right now, a top of mind concern that could undermine the central bank’s credibility if it gets worse, erodes household spending power and begins distorting the investment and spending decisions of businesses and families.

The job market, Powell noted in prepared testimony, was "extremely tight," and Fed officials have declared their maximum employment goal effectively met. The pandemic's impact on the economy appeared to be easing and "demand is strong," Powell said.

However inflation is currently triple the Fed's 2% target, and has become a prime political concern for the Biden administration and members of Congress who came to Wednesday’s hearing armed with anecdotes of constituents paying more for staple goods or for business supplies.

What Powell described as a collision between strong consumer demand and pandemic constraints on global product supply was "not as transitory as we had hoped...Other mainstream economists and central banks around the world made the same mistake. That doesn’t excuse it, but we thought these things would be resolved long ago.”

FRAMED BY UKRAINE CONFLICT

But even with the immediate focus on inflation, Powell's testimony was framed by the conflict in Ukraine, and what it might mean for the United States and world economies in the weeks or even years ahead.

Powell said that Fed staff had begun analyzing different scenarios but that too much remained unknown about an event whose full implications may "be with us for a very long time."

"The near-term effects on the U.S. economy of the invasion of Ukraine, the ongoing war, the sanctions, and of events to come, remain highly uncertain," Powell said. "Making appropriate monetary policy in this environment requires a recognition that the economy evolves in unexpected ways. We will need to be nimble in responding to incoming data and the evolving outlook."

"We will proceed carefully as we learn more about the implications of the Ukraine war on the economy," Powell said. "We have an expectation that inflation will peak and begin to come down this year. To the extent inflation comes in higher or is more persistently high ... we would be prepared to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings."

The Fed slashed rates to the current near zero level in 2020 to blunt the impact of the coronavirus pandemic. There is now broad agreement that the current level of borrowing costs is out of phase with an economy that has rebounded faster than expected from the health crisis.

Lawmakers peppered Powell with questions about the fallout from rising oil prices following Russia's action, the threat of cyberattacks and broader risks to the financial system, and even the impact on the market for fertilizer.

"Everything we can do ... we are doing it," to protect against a cyberattack, Powell said. "The larger financial institutions are doing it. It's hard to say what's possible, but we are on high alert and will continue to be."

Regarding financial markets, Powell said that so far they have been "functioning well. There is a great deal of liquidity out there," and existing Fed programs were helping.

Powell will appear before the Senate Banking Committee on Thursday. The Fed chief is required to testify to those House and Senate committees twice a year as part of the central bank's semiannual reviews of monetary policy.

Major U.S. stock indexes were trading sharply higher, extending their gains during Powell's testimony, and yields on Treasuries rose. The U.S. dollar was little changed against a basket of major trading partner currencies. Traders in interest rate futures began pricing in six quarter-point rate hikes this year versus five as of Tuesday.

Powell, "preferred to keep the Fed's options open ... there was little pushback on current market rate expectations, which have plummeted since Russia's invasion," said Paul Ashworth, chief U.S. economist at Capital Economics.