Investors Nervously Eye the Fed

American stock indexes dropped sharply Monday, and a key bond market signal pointed to recession risks, indicating that investors are bracing for economic fallout as central banks — including the Federal Reserve — try to rein in rapid inflation.

The Fed, which will release its latest monetary policy decision and a fresh set of economic projections this Wednesday, had signaled that it will probably raise interest rates by half a percentage point this week and by another half a point in July. But following a surprisingly hot Consumer Price Index report on Friday, which showed inflation reaccelerating to 8.6 percent and touching a new four-decade high, investors began to pencil in an even larger move by its September meeting.

Wall Street is braced for interest rates to rise to a range of 2.5 to 2.75 percent as of the Fed’s September gathering, suggesting central bankers would need to make one three-quarter point move over the course of its next three meetings — possibly as soon as July. The Fed hasn’t made such a large move since 1994, and that 2.75 percent upper limit would be the highest the federal funds rate has been since the global financial crisis in 2008.

When the Fed lifts its policy interest rate, it filters through the economy to make borrowing of all kinds — including mortgage debt and business loans — more expensive. That slows down the housing market, keeps consumers from spending so much and cools off corporate expansions, weakening the labor market and broader economy. Slower demand can help price pressures to ease as fewer buyers compete for goods and services.

But interest rates are a blunt tool, so it is difficult to slow the economy with precision. Likewise, it is tough to predict how much conditions need to cool to bring inflation down convincingly. Supply issues tied to the pandemic could ease, allowing for a deceleration. But the war in Ukraine and China’s newly reimposed lockdowns meant to contain the coronavirus could keep prices elevated.

That is why investors and households increasingly fear that the central bank will set off a recession. Consumer confidence is plummeting, and a bond-market signal that traders monitor closely suggests that a downturn may be coming. The yield on the 2-year Treasury note, a benchmark for borrowing costs, briefly rose above the 10-year yield on Monday. That so-called inverted yield curve, when it costs more to borrow for shorter periods than longer periods, typically does not happen in a healthy economy and is often taken as a sign of an impending downturn.

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