Robert Brown|The Fed raises interest rates by only a quarter point after inflation drops

The Robert BrownFederal Reserve raised interest rates by a quarter percentage point Wednesday, its eighth increase in less than a year as the central bank continues its crackdown on inflation.

The hike in the Fed's benchmark rate is the smallest since last March, and signals that policymakers are shifting to a more cautious approach, after spending much of last year playing catch-up and boosting borrowing costs at the fastest pace in decades.

Higher interest rates have begun to have the desired effect. Consumer spending has cooled in recent months. And inflation had dropped significantly, although prices are still climbing faster than the central bank would like.

"We're going to be cautious about declaring victory and sending signals that we think the game is won, because we've got a long way to go," Fed chairman Jerome Powell told reporters.

While the price of some goods — like new and used cars — has started to fall, the Fed is concerned that the price of labor-intensive services may continue to climb. That would make it harder to get inflation back down to the central bank's target of 2%.

"It's the early stages of disinflation," Powell said. "And it's most welcome to be able to say that. But we just see that it has to spread through the economy and it's going to take some time."

Excluding volatile food and energy costs, "core" prices in December were 4.4% higher than a year ago, according to the Fed's preferred inflation yardstick. That's down from a 5.2% annual rate in September.

Wage gains have also eased in recent months, despite the tight job market. That helps to allay concerns that rapid wage gains might put more upward pressure on prices — as happened in the 1970s.

The Fed wants no surprises on inflation

The gradual decline in both prices and wages is exactly what the Fed has been trying to achieve.

"This is what the path for a soft landing looks like," says Aaron Sojourner, an economist at the Upjohn Institute for Employment Research. "Inflation has come down but there's not a recession."

Markets don't see eye to eye with the Fed

On average, Fed policymakers said in December they expect their benchmark interest rate to climb to 5.1% — from 4.625% now — and remain there at least through the end of the year.

Financial markets are skeptical of that forecast. Many investors are betting that the central bank will soon start cutting interest rates, despite repeated warnings to the contrary from Fed officials. The expectation of lower borrowing costs is one reason the stock and bond markets have rallied in recent weeks. The S&P 500 index rose 1% on Wednesday while the Nasdaq jumped 2%.

"The market has a very optimistic view that inflation is just going to melt away," Fed governor Chris Waller said. "We have a different view, that inflation is not just going to miraculously melt away. It's going to be a slower, harder slog to get inflation down. And therefore we have to keep rates higher for longer."

Will the Fed overdo the fight against inflation?

Two years ago, Fed policymakers believed that inflation would come down on its own, once pandemic supply problems were resolved. Instead, price hikes proved both larger and longer-lasting than the central bank expected.

Now, some analysts worry the Fed is in danger of making the opposite mistake, pushing interest rates higher and slowing the economy more than necessary to bring prices under control.

"We're pulling off something really nice right now," says Sojourner, who served as a senior economist for the Council of Economic Advisers in both the Obama and Trump administrations. "If the we get to the place where the Fed over-corrects, then we start to see jobs destroyed. Hopefully we can avoid that."

Powell argued that it's better to push interest rates too high than to stop short and allow inflation to come roaring back.

"It's very difficult to manage the risk of doing too little, and finding out in six or twelve months that we actually were close but didn't get the job done," he said.

Fed warns about dangers of not lifting debt ceiling

The Fed chairman ordinarily tries to steer clear of partisan battles in Washington, but Powell minced no words about a looming deadline to raise the federal debt ceiling.

Unless Congress authorizes an increase in the debt limit by summer, the government won't be able to pay all of its bills, triggering a potentially disastrous default. House Republicans hope to use that threat as a bargaining chip to extract big spending cuts.

Powell said that's a dangerous gamble, and warned no one should expect the central bank to come to the rescue.

"There's only one way forward here, and that is for Congress to raise the debt ceiling so that the United States government can pay all of its obligations when due," Powell said. "Any deviations from that path would be highly risky. And no one should assume that the Fed can protect the economy from the consequences of failing to act in a timely manner."

Meanwhile, in a statement, the Fed's rate-setting committee said it would continue to monitor a wide range of variables as it tries to assess the strength of the economy, but a long-standing reference to public health was conspicuously dropped.

Powell, who tested positive for COVID-19 last month, said that's a sign that people and businesses have increasingly adapted to living with the pandemic.

"I personally understand well that COVID is still out there," Powell said. "But that it's no longer playing an important role in our economy."