Fed Slows Its Tightening With Quarter-Point Interest Rate Rise

Officials agreed to slow rate rises to gain more time to study the effects of their moves. “We’re talking about a couple of more rate hikes to get to that level we think is appropriately restrictive,” Fed Chair

Jerome Powell

said at a news conference after the central bank’s policy meeting.

Despite signs that wage and price growth might have peaked several months ago, “We’re going to be cautious about declaring victory and sending signals that we think that the game is won,” he said.

Investors welcomed the decision, with the S&P 500 closing up about 1%, to 4119.21, while the Nasdaq Composite advanced by 2% to 11816.32. The Dow Jones Industrial Average rose 6.92 points to 34092.96. The yield on the benchmark 10-year U.S. Treasury note declined to 3.398% from 3.527% the previous day. Yields fall when prices rise.

The latest increase caps a year in which the Fed lifted the fed-funds rate from near zero to a range between 4.5% and 4.75%, a level last reached in 2007, extending the central bank’s most rapid interval of rate increases since the early 1980s.

Mr. Powell and Fed officials tried not to feed speculation regarding a rate pause. For example, they left unchanged the guidance in their postmeeting policy statement that has said since last March that they anticipate “ongoing increases” in interest rates “will be appropriate.”

But government-bond investors thought they smelled a coming pause anyway, analysts said, because they expect the cumulative effect of last year’s rate increases to slow the economy sharply this year.

“Markets rallied fiercely despite the hawkish message because investors know the Fed isn’t omniscient nor is it dogmatic,” said Daleep Singh, a former senior Fed official who is now chief global economist at PGIM Fixed Income. “Economic conditions are in charge when the Fed is in data-dependent mode.”

Since Fed officials met in December, economic activity has been mixed. Hiring has held steady, pushing the unemployment rate down to 3.5% in December, a half-century low.

But consumer spending has moderated, and manufacturing activity has declined, an indication of weakness extending beyond the hard-hit housing sector. “Markets have essentially ignored the Fed meeting and are reacting to those data,” said Mr. Singh.

The fed-funds rate influences other borrowing costs throughout the economy, including rates on mortgages, credit cards and auto loans. The Fed is raising rates to cool inflation by slowing economic growth. It believes those policy moves work through financial markets by tightening financial conditions, such as by raising borrowing costs or lowering prices of stocks and other assets.

In recent weeks, markets have rallied partly because investors anticipated that the Fed would slow its rate increases this week and remove uncertainty regarding the rate outlook, which reduces interest-rate volatility. Lower volatility can ease financial conditions. Investors also think a sharp slowdown will lead the Fed to cut rates by year’s end.

In December, most Fed officials penciled in raising the fed-funds rate to a range between 5% and 5.25% this year, with none projecting cuts. After the hike that they approved Wednesday, that projection would imply additional quarter-point increases at the Fed’s meetings in March and May, followed by a pause in rate rises.

Mr. Powell indicated Wednesday they would base their decisions and any revision to those projections on fresh reports of hiring, inflation and growth before their next meeting, March 21-22.

“Certainty is just not appropriate here,” said Mr. Powell. “I’m not going to try to persuade people to have a different forecast, but our forecast is that it will take some time and some patience, and that we’ll need to keep rates higher for longer.”

Mr. Powell and other economists are concerned that the recent decline in inflation could reflect the long-anticipated easing of supply-chain bottlenecks—and that might not be enough to bring inflation down to the Fed’s 2% goal.

“I’m somewhat worried that the market view is based more on hope,” said

Karen Dynan,

an economist at Harvard University who served in the Obama administration. “Labor markets still look really tight.”

Mr. Powell repeated his earlier view that a tight labor market would keep upward pressure on wages and prices even though they have moderated recently. He also cited reasons the economy might prove resilient, including from an increase in public spending on construction projects and an increase in inflation-adjusted wages as price increases slow this year.

“The Fed is focused on the last mile, and so far, there has not been enough evidence of a slowdown that will get inflation down to 2%,” said

Kristin Forbes,

a professor at the Massachusetts Institute of Technology and former member of the Bank of England’s Monetary Policy Committee.

Overall inflation is slowing largely because prices of energy and other goods are falling. Large increases in housing costs have slowed, but haven’t filtered through to official price gauges yet. As a result, Mr. Powell and several colleagues shifted attention recently toward a narrower subset of labor-intensive services by excluding prices for food, energy, shelter and goods.

Inflation fell to 4.4% in December from 5.2% in September, as measured by the 12-month change in the personal-consumption expenditures price index excluding food and energy. Though still above the Fed’s 2% goal, it moderated in the October-to-December period to an annualized 2.9% rate. But prices in the narrow category of nonhousing services rose 4% in December over both the past year and at a three-month annualized rate.

Ray Farris, chief economist at Credit Suisse, said the Fed is likely to continue to signal it will hold rates at a higher level for longer than the market expects to prevent inflation from picking up again or settling at an uncomfortably high level. That posture could reflect officials’ regret, in retrospect, at waiting too long to withdraw reservoirs of stimulus in the second half of 2021, he said.

“They have to live with the perception that they blew it. And they can’t blow it on the way down,” said Mr. Farris. “The Fed cannot be in a position where it declares victory at 3.5% inflation, only to have some random new shock in the system push headline inflation back up to 5%.”

Indeed, Mr. Powell suggested that he continued to see the risk of not raising rates enough and allowing inflation to reaccelerate to be more dangerous than raising rates too high and causing a recession. In the latter alternative, the Fed could react immediately by cutting rates, he said.

The first mistake would be harder to fix because it would risk a period of more entrenched inflation that would ultimately require a deeper recession to break consumers’ and business expectations of higher prices, he said. “I continue to think that it’s very difficult to manage the risk of doing too little and finding out in six or 12 months that we actually were close but didn’t get the job done and inflation springs back,” Mr. Powell said.

Write to Nick Timiraos at nick.timiraos@wsj.com

Corrections & Amplifications
Fed officials left unchanged the guidance in their postmeeting policy statement that has said since last March that they anticipate “ongoing increases” in interest rates “will be appropriate.” An earlier version of this article incorrectly said the statement said those increases “are likely appropriate.” (Corrected on Feb. 1)

Officials agreed to slow rate rises to gain more time to study the effects of their moves. “We’re talking about a couple of more rate hikes to get to that level we think is appropriately restrictive,” Fed Chair

Jerome Powell

said at a news conference after the central bank’s policy meeting.

Despite signs that wage and price growth might have peaked several months ago, “We’re going to be cautious about declaring victory and sending signals that we think that the game is won,” he said.

Investors welcomed the decision, with the S&P 500 closing up about 1%, to 4119.21, while the Nasdaq Composite advanced by 2% to 11816.32. The Dow Jones Industrial Average rose 6.92 points to 34092.96. The yield on the benchmark 10-year U.S. Treasury note declined to 3.398% from 3.527% the previous day. Yields fall when prices rise.

The latest increase caps a year in which the Fed lifted the fed-funds rate from near zero to a range between 4.5% and 4.75%, a level last reached in 2007, extending the central bank’s most rapid interval of rate increases since the early 1980s.

Mr. Powell and Fed officials tried not to feed speculation regarding a rate pause. For example, they left unchanged the guidance in their postmeeting policy statement that has said since last March that they anticipate “ongoing increases” in interest rates “will be appropriate.”

But government-bond investors thought they smelled a coming pause anyway, analysts said, because they expect the cumulative effect of last year’s rate increases to slow the economy sharply this year.

“Markets rallied fiercely despite the hawkish message because investors know the Fed isn’t omniscient nor is it dogmatic,” said Daleep Singh, a former senior Fed official who is now chief global economist at PGIM Fixed Income. “Economic conditions are in charge when the Fed is in data-dependent mode.”

Since Fed officials met in December, economic activity has been mixed. Hiring has held steady, pushing the unemployment rate down to 3.5% in December, a half-century low.

But consumer spending has moderated, and manufacturing activity has declined, an indication of weakness extending beyond the hard-hit housing sector. “Markets have essentially ignored the Fed meeting and are reacting to those data,” said Mr. Singh.

The fed-funds rate influences other borrowing costs throughout the economy, including rates on mortgages, credit cards and auto loans. The Fed is raising rates to cool inflation by slowing economic growth. It believes those policy moves work through financial markets by tightening financial conditions, such as by raising borrowing costs or lowering prices of stocks and other assets.

In recent weeks, markets have rallied partly because investors anticipated that the Fed would slow its rate increases this week and remove uncertainty regarding the rate outlook, which reduces interest-rate volatility. Lower volatility can ease financial conditions. Investors also think a sharp slowdown will lead the Fed to cut rates by year’s end.

In December, most Fed officials penciled in raising the fed-funds rate to a range between 5% and 5.25% this year, with none projecting cuts. After the hike that they approved Wednesday, that projection would imply additional quarter-point increases at the Fed’s meetings in March and May, followed by a pause in rate rises.

Mr. Powell indicated Wednesday they would base their decisions and any revision to those projections on fresh reports of hiring, inflation and growth before their next meeting, March 21-22.

“Certainty is just not appropriate here,” said Mr. Powell. “I’m not going to try to persuade people to have a different forecast, but our forecast is that it will take some time and some patience, and that we’ll need to keep rates higher for longer.”

Mr. Powell and other economists are concerned that the recent decline in inflation could reflect the long-anticipated easing of supply-chain bottlenecks—and that might not be enough to bring inflation down to the Fed’s 2% goal.

“I’m somewhat worried that the market view is based more on hope,” said

Karen Dynan,

an economist at Harvard University who served in the Obama administration. “Labor markets still look really tight.”

Mr. Powell repeated his earlier view that a tight labor market would keep upward pressure on wages and prices even though they have moderated recently. He also cited reasons the economy might prove resilient, including from an increase in public spending on construction projects and an increase in inflation-adjusted wages as price increases slow this year.

“The Fed is focused on the last mile, and so far, there has not been enough evidence of a slowdown that will get inflation down to 2%,” said

Kristin Forbes,

a professor at the Massachusetts Institute of Technology and former member of the Bank of England’s Monetary Policy Committee.

Overall inflation is slowing largely because prices of energy and other goods are falling. Large increases in housing costs have slowed, but haven’t filtered through to official price gauges yet. As a result, Mr. Powell and several colleagues shifted attention recently toward a narrower subset of labor-intensive services by excluding prices for food, energy, shelter and goods.

Inflation fell to 4.4% in December from 5.2% in September, as measured by the 12-month change in the personal-consumption expenditures price index excluding food and energy. Though still above the Fed’s 2% goal, it moderated in the October-to-December period to an annualized 2.9% rate. But prices in the narrow category of nonhousing services rose 4% in December over both the past year and at a three-month annualized rate.

Ray Farris, chief economist at Credit Suisse, said the Fed is likely to continue to signal it will hold rates at a higher level for longer than the market expects to prevent inflation from picking up again or settling at an uncomfortably high level. That posture could reflect officials’ regret, in retrospect, at waiting too long to withdraw reservoirs of stimulus in the second half of 2021, he said.

“They have to live with the perception that they blew it. And they can’t blow it on the way down,” said Mr. Farris. “The Fed cannot be in a position where it declares victory at 3.5% inflation, only to have some random new shock in the system push headline inflation back up to 5%.”

Indeed, Mr. Powell suggested that he continued to see the risk of not raising rates enough and allowing inflation to reaccelerate to be more dangerous than raising rates too high and causing a recession. In the latter alternative, the Fed could react immediately by cutting rates, he said.

The first mistake would be harder to fix because it would risk a period of more entrenched inflation that would ultimately require a deeper recession to break consumers’ and business expectations of higher prices, he said. “I continue to think that it’s very difficult to manage the risk of doing too little and finding out in six or 12 months that we actually were close but didn’t get the job done and inflation springs back,” Mr. Powell said.

Write to Nick Timiraos at nick.timiraos@wsj.com

Corrections & Amplifications
Fed officials left unchanged the guidance in their postmeeting policy statement that has said since last March that they anticipate “ongoing increases” in interest rates “will be appropriate.” An earlier version of this article incorrectly said the statement said those increases “are likely appropriate.” (Corrected on Feb. 1)