The Federal Reserve is expected to raise interest rates by a quarter-percentage point at its meeting on Wednesday, entering a high-stakes chapter in its battle against high inflation.

The central bank is on track to issue its smallest rate hike since March 2021, when the Fed began aggressively boosting borrowing costs and slowing the economy into lower price growth.

But the Fed faces serious risks on both sides of a potential pause to rate hikes.

If the Fed stops too soon, bank officials fear that high inflation could become entrenched. If it stops too late, the central bank could trigger a serious, job-killing recession. Adding to the uncertainty is the fact that the Fed’s rate hikes affect the economy at a lag.

“This is like trying to steer a large cruise ship through a storm. They have very blunt controls and they operate at a lag, and they don’t have great visibility right now,” said Aaron Sojourner, a labor economist with the Upjohn Institute for Employment Research, in an interview with The Hill.

The Fed under pressure to stop rate hikes

With inflation fading and the economy slowing, the central bank is under pressure to stop raising rates altogether. While Fed officials are reluctant to declare victory against inflation, they have acknowledged the economy no longer needs supersized rate hikes to cool it off. 

While markets currently expect modest rate hikes at the Fed’s meeting this week and at its next meeting in March, the central bank may indicate Wednesday that hikes will continue into May.

“The job of the Fed is to — as carefully and consciously as we can — navigate through this so that there’s the least pain in the economy as possible while we restore price stability,” said Mary Daly, president of the Federal Reserve Bank of San Francisco, in an interview with NPR earlier this month.

“We’re going to be conscious that we need to slow the pace of increases, look around, watch the data, see how things are coming out, and then make decisions meeting by meeting by meeting.”

Fed officials expect to hike interest rates again by a total of 0.75 percentage points before the end of 2023, according to projections released in December. That would require two more hikes of at least 25 basis points before the end of the year after its likely Wednesday increase.

Some investors think the Fed needs to keep going with higher rate hikes in order to hit its earlier projection and stay in line with business expectations.

“The Fed are battling market, household, and business expectations and if they were to come up short of their stated terminal rate, it may negatively impact their credibility,” Joe Davis, an economist with investment company Vanguard Group, wrote in an analysis. 

Other economists believe recent data should push the Fed toward a sooner pause.

The personal consumption expenditures (PCE) price index, the Fed’s preferred measure of inflation, fell to an annual increase of 5 percent in December from a June high of 6.8 percent. The better-known consumer price index (CPI) dropped to 6.5 percent annually in December from a high of 9.1 percent in June.

Economy shows signs of slowing down

The U.S. economy is also showing more signs of slowing from its record-breaking rebound, with gross domestic product (GDP) rising 2.1 percent on the year in 2022 and job gains slowing for five consecutive months. 

And the Labor Department’s Employment Cost Index (ECI), the Fed’s primary gauge of wage growth, rose 1 percent during the fourth quarter, the slowest increase since the start of 2022.

“The real risk is that they raise rates too high or that they hold them too high for too long … but it seems like there’s a possibility that we’re in for a soft landing, which means there aren’t a lot of jobs destroyed,” Sojourner said.

These downward trajectories have some Fed watchers saying that the Fed should hit the brakes on rate hikes after Wednesday. They argue that the price-dampening effects of previous hikes have yet to be fully felt and that the pain of a deep recession would be worse than having inflation land above the Fed’s target rate of 2 percent annually.

“The markets are now seeing clearly that the inflation spike [between the second quarter of 2021 and the third quarter of 2022] is proving to have been pandemic-related – not the result of a larger and more sustainable macroeconomic shift,” investor and Westwood Capital founder Dan Alpert said in an email to The Hill. 

“Whether or not everyone [at the Fed] agrees with this premise is less important than the real-world risks of continuing an extreme tightening of monetary policy when you know that the lagged effects of that policy have not yet been seen,” Alpert said.

Fed’s goal of a ‘soft landing’ not guaranteed

Avoiding both entrenched inflation and a recession will mean the Fed has achieved its desired goal of “soft landing,” but even with inflation easing that outcome is far from guaranteed.

Fed officials expect the unemployment rate to rise to 4.6 percent by the end of the year, more than 1 percentage point higher than the December jobless rate of 3.5 percent, according to projections released in December.

Fed Chair Jerome Powell and other bank leaders have argued that an increase in the jobless rate of that size does not necessarily mean the U.S. is in a recession. Many experts, however, doubt the Fed could achieve that increase without serious economic harm.

“The unemployment rate has only increased by 1 percent within a year twelve times since World War II. Every time, we saw a recession [and] the unemployment rate continued to increase far beyond the initial 1 percent,” wrote senior economist Alex Williams in a January analysis for Employ America, a think tank that advocates for high employment levels in the U.S. economy.

Tapering rate hikes by the Fed will be felt throughout the economy and especially in sectors that are sensitive to the cost of financing. The average 30-year-fixed-rate mortgage rate has ticked down to 6.13 percent while average credit rates, which are variable, have soared about 20 percent.

“The markets are projecting one 25 [basis point] rate hike on Feb. 1, and another 25 bp hike on March 22. They expect a pause after that, and modest rate cuts at the end of the year. At this point, those market projections are not unreasonable,” Boston College economist Brian Bethune wrote in an email to The Hill.