Fed Tees Up March Interest-Rate Increase

The central bank approved one final round of asset purchases, which will bring that stimulus program to a conclusion by March. Officials continued deliberations at their two-day meeting over how and when to shrink the Fed’s $9 trillion securities portfolio, which has more than doubled since March 2020.

The Fed released a separate one-page statement that spelled out high-level principles to guide a process for “significantly reducing” those holdings.

The Fed cut short-term interest rates to near zero and started buying bonds to lower long-term rates in 2020 as the coronavirus pandemic hit the U.S. economy, triggering financial-market volatility and a deep, short recession.

Officials pledged to hold interest rates near zero until inflation was forecast to moderately exceed 2% and until the labor market returned to levels consistent with maximum employment.

The Fed indicated in its statement that these goals were effectively met. The central bank also removed a key opening sentence from its statement that it had used since March 2020 to signal it would aggressively support growth amid an unprecedented global pandemic.

Brisk demand for goods and shortages for intermediate goods such as semiconductors have pushed inflation to its highest 12-month readings in decades. Inflation rose 5.7% in November from a year earlier, using the Fed’s preferred gauge, and easily surpassed the Fed’s first objective.

But it has been developments in the labor market that provided greater urgency in recent weeks for the Fed to accelerate plans to raise rates much faster than officials anticipated last summer.

Sharp wage gains and a historic drop in the unemployment rate over the second half of last year—to 3.9% in December from 5.9% in June—led officials Wednesday to declare their employment-related goal had also been achieved.

The Fed’s decisions on Wednesday had been well telegraphed. “It is really time for us to begin to move away from those emergency pandemic settings to a more normal level,” Fed Chairman Jerome Powell told lawmakers earlier this month. “It’s a long road to normal from where we are.”

Fed officials face a tricky task of responding to high inflation with two different policy instruments, which could provide more ammunition to slow the economy, but which have in the past caused confusion with markets.

Mr. Powell and his colleagues have indicated they will start the process of shrinking their asset holdings sooner than they did after the central bank stopped buying bonds in 2014. They have also indicated that the process of shrinking those holdings—by allowing securities to mature without reinvesting their proceeds into new ones—is likely to proceed faster than it did the last time the Fed reduced its holdings in 2017.

The Fed said Wednesday that it wants adjustments of its short-term benchmark interest rate, the federal-funds rate, to be the primary way that it responds to changes in the economic outlook. Officials have indicated they would again opt for a path for unwinding their asset holdings that runs on a premapped schedule once they have raised rates. But the statement provided no guidance about when that process might start.

The prospect of more interest-rate increases and a shrinking Fed portfolio to reduce inflation has led to heightened market volatility in recent days, prompting investors to sell shares of some technology companies, cryptocurrencies and other risky assets that enjoyed a boom last year.

The Fed’s turn to tighten policy “is definitely not a sudden revelation and has been more of an evolution, so why the market has just now gotten the message is a little confounding,” said Tom Graff, head of fixed income and portfolio manager at Brown Advisory.

Mr. Graff said markets have taken the Fed’s promises of tighter monetary policy more seriously after officials earlier this month signaled they had begun contemplating plans to shrink their asset portfolio. “If your thesis was that a particular stock valuation made sense because interest rates were always going to remain extremely low, then that was on borrowed time,” he said.

For months last year, Mr. Powell and his colleagues said they didn’t need to raise rates to bring inflation down because they believed high readings stemmed primarily from supply-chain bottlenecks and other difficulties associated with reopening the economy.

Mr. Powell changed course in November and said that the central bank was concerned inflation might become entrenched. That set in motion a policy pivot that has been rapid by Fed standards, given its preference to move in measured steps to avoid whipsawing markets.

The pivot reflected a shifting calculus about the potential for stronger demand to push up prices such as wages and rents that could keep inflation elevated even after bottlenecks and shortages of items such as cars and trucks abate.

Officials are giving more weight to the prospect that the aggressive fiscal- and monetary-policy responses to the pandemic altered traditional recessionary dynamics, buoying wage growth that normally takes longer to recover after a downturn.

A sharp run-up in home values, stocks and other assets has boosted wealth for many Americans, fueling stronger demand and potentially allowing some to retire earlier than they had anticipated, tightening the labor market.

President Biden has nominated Mr. Powell for a second term as Fed chief when his current one expires next week. At his confirmation hearing two weeks ago, Mr. Powell said officials had been surprised not only by the intensity of certain price pressures last year, but also by a drop in the number of Americans seeking jobs despite a high number of vacancies.

While he said those labor shortages weren’t driving current high inflation, a smaller labor force “can be an issue going forward for inflation, probably more so than these supply-chain issues,” Mr. Powell said.

Central-bank officials last month penciled in three quarter-percentage-point interest rate increases this year and three more next year. They based the projections for the increases on a forecast that sees inflation falling below 3% by December and to slightly more than 2% by the end of next year.

Still, several officials have stressed that there is great uncertainty around that forecast, and investors are hungry for clues about how the Fed would react if inflation looks likely to stay above 3% around the end of this year.

Write to Nick Timiraos at [email protected]