Fed to start hiking in 50bp steps

Specifically, Chair Powell’s remark that the Fed faces an 'obvious need to move expeditiously' in raising rates to neutral levels, alongside the statement that ‘nothing’ would stop the Fed hiking in 50bp steps if it judged necessary, were clear signals to us that the Committee is actively considering larger tightening steps than we previously thought. Since then, the fact that market sentiment has continued to recover (also on the back of increased optimism over the Russia-Ukraine conflict) has in our view given the Fed a green light to go ahead with this more aggressive approach to tightening monetary policy.

As such, we now pencil in 50bp rate hikes in both the May and the June FOMC meetings. Thereafter, we expect the Fed to switch to a more gradual pace of 25bp hikes at each meeting, until it reaches our expectation of the terminal rate of 2.5-2.75% in early 2023. This assumes that monthly core inflation readings show some signs of cooling, and that consumption indicators such as retail sales track the recent fall in consumer confidence lower. If this does not happen, the Fed could well judge that it needs to continue tightening policy at this faster pace.

…while keeping the expected peak in the fed funds rate at 2.50-2.75%

Although we have significantly brought forward our expected policy tightening by the Fed, we continue to think the Committee will pause tightening once it reaches a level just above the neutral rate, at 2.5-2.75%, for two key reasons. First, while the surge in energy prices following the outbreak of the Russia-Ukraine conflict could push inflation expectations even higher, this risk must be weighed against the significant growth dampening effects higher energy prices are having. We expect the effects of higher gasoline prices in particular to already weigh on consumption in Q2, but the pandemic rebound in services – alongside an eventual recovery from supply-side bottlenecks – will likely prevent the economy entering a major downturn.

However, the Fed is likely to judge that demand-side pressures – particularly for goods, where the bulk of inflationary pressure has originated – will have significantly abated by early 2023. Alongside a convincing turn in inflation dynamics, this should give the Committee confidence that it is on course to bring inflation back to target.

Second, and related to this, monetary policy works with a significant lag – up to 18-24 months. Given our expectation that the economy will already be slowing significantly into 2023, the Fed is unlikely to want to accentuate such a slowdown, assuming that inflation is moving quickly back to target. With that said, there are risks to our view. First, there is the risk that inflation fails to cool as we expect over the coming year (our base case is that inflation will still be well above target next year, but significantly lower than it is now).

The second risk concerns the Fed’s reaction function. The Committee has turned materially much more hawkish in a very short space of time. It is possible therefore that it may not be satisfied that it has sufficiently tightened until it sees realised inflation come back to target. In that scenario, excessively tight policy could ultimately trigger a more lasting downturn. (Bill Diviney)