In testimony to Congress this week, Federal Reserve Chairman Jerome Powell indicated strongly that interest rates are heading higher than previously believed. Because inflation data for recent months have been uncomfortably high and because the economy continues to show signs of strong growth, the Federal Reserve believes that the terminal rate for interest rates, that is where the Federal Reserve will stop raising rates, might be higher than the current projected stopping point of 5.25%-5.50%.

Powell’s testimony elicited an immediate market reaction. The interest rate futures market increased the probability of a 0.50% interest rate hike at the March 21-22 Federal Reserve meeting to over 65%. This is a much more aggressive stance than the previously anticipated 0.25% increase. And the futures market now says the terminal rate for interest rates will be over 5.6%.

As interest rates increase, the risk of a recession rises. Powell acknowledged that higher rates would bring higher unemployment. He explained that near-term economic pain is necessary for long-term prosperity.

Powell laid out the case for why the Federal Reserve must continue to raise interest rates to achieve price stability, defined as 2% inflation. Powell explained that without price stability, the economy does not work for anyone. He testified that "without price stability, we will not achieve a sustained period of labor market conditions that benefit all."

With price stability, business is able to focus on maximizing profits and reinvesting those profits in productivity-enhancing endeavors. With price stability, households can focus on making personal consumption and savings decisions without the distraction of how to navigate a high-inflation environment. Powell noted that economic data showed that inflation has stopped decelerating. He explained that over the past 12 months, core personal consumption expenditure inflation, which excludes volatile food and energy prices, was 4.7%.

Inflation is sticky and elevated because the labor market remains extremely tight. The unemployment rate was 3.4% in January, its lowest level since 1969. Job gains remained very strong in January. As of the end of December 2022, there were 1.9 job openings for each unemployed person, close to the all-time peak recorded in early 2022. At the beginning of this year, the U.S. economy had 170 million jobs but only 166 million available workers. That is the definition of a tight labor market.

With the tight labor market, wage gains are trending well above levels consistent with 2% inflation. Wage gains, which are running around 6%, need to fall to around 3.5% to be consistent with 2% inflation, as secular productivity growth is about 1.4%-1.5%. Much higher interest rates are necessary to create slack in the labor market.

Powell concluded his prepared remarks by explaining that well-anchored inflation expectations are essential to price stability. Restoring price stability is essential for achieving maximum employment. Powell’s affirmation that the Federal Reserve will do its job is anchoring longer-dated Treasury yields, which are important in setting mortgage rates and loans for consumer durables. Importantly, the yield on the 10-year Treasury remains stable.

The market has confidence in Powell and the Federal Reserve. Inflation expectations are anchored.

James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes  a daily note  on finance and the economy, politics, sociology, and criminal justice.