Markets are cranking up their expectations for Fed interest rate hikes

Published Fri, Apr 22 202212:32 PM EDTUpdated Fri, Apr 22 20223:40 PM EDT

Investors have dramatically changed their views on how quickly the Federal Reserve will raise interest rates in the coming months as the central bank tries to put out the inflation fire. Expectations now have coalesced around a 50-basis-point move in May that will be followed by a 75-basis-point increase in June. The latter increase would represent the biggest move since the Alan Greenspan-led Fed jacked up rates by three-quarters of a percentage point in 1994. A basis point equals 0.01%. Recent statements from Fed officials — particularly the remarks by Chair Jerome Powell — have convinced markets that officials view inflation fighting as a top priority and will move quickly. "We expect 75bp hikes at the June and July [Federal Open Market Committee] meetings after 50bp in May," Nomura economists led by Aichi Amemiya wrote in a note Thursday. "We believe momentum for a 75bp rate hike at some point later this year has increased; we now expect a 75bp hike at both the June and July FOMC meetings, following a widely expected 50bp hike in the May meeting." "Hikes of 50bp in May and 75bp in both June and July would bring rates to the FOMC's perceived neutral setting very quickly," the firm added. The comments come a day after Powell said the rate-setting FOMC would entertain a 50-basis-point move at the May 3-4 meeting. He emphasized the importance of fighting inflation and said the labor market is "historically tight" and pressuring wages. Markets reacted by fully pricing in the 50-basis-point move next month then added further escalation by the end of the year that would take the fed funds rate to 2.75%. Overnight, traders increased the chances for yet another move to 48.2%, according to CME Group data Friday morning. "I think markets are processing what we're saying. They're reacting appropriately generally, but I wouldn't want to bless any particular market pricing," Powell said prior to the moves in fed funds futures. "We really are committed to using our tools to get 2% inflation back." The Fed chief added that he supports a "front-loaded" approach to raising rates. Critics gather While Powell's comments reflected little in the way of new thinking from the Fed — multiple policymakers recently have discussed the likelihood of a half-percentage-point move — they nonetheless moved markets and underlined the institution's hawkish posture. The switch to rate hiking also represents an about-face from officials who until just six months ago had insisted the surge in inflation was "transitory" and not a cause for policy adjustments. However, a recent New York Fed paper flipped the script, noting that while the initial inflation rise came from pandemic-specific cyclical factors, more recent moves are "not explained by a single sector or group of sectors but is more pervasive." That recent reluctance to raise rates attracted detractors ranging from former Treasury Secretary Larry Summers to Allianz economic advisor Mohamed El-Erian, both of whom have argued the Fed is well behind the inflation curve and needs to get aggressive or risk broader economic damage. Even with the change in rhetoric, there is still concern that the Fed is wading too slowly into tightening and is risking more trouble by not communicating its intentions clearly enough. Bullard's 'trial balloon' Earlier in the week, St. Louis Fed President James Bullard suggested the FOMC should consider a 75-basis-point increase in May. Bullard has been perhaps the Fed's most hawkish member , insisting that gradual rate hikes won't help take down inflation. Markets took another hawkish signal from San Francisco Fed President Mary Daly, who as a policy dove usually favors lower rates and less restrictive policy. Daly said she would consider a 75-basis-point hike, though it's not her most likely scenario. "Is it 50, is it 25, is it 75? Those are things that I'll deliberate with my colleagues, but my own starting point is we don't want to go so quickly or so abruptly that we surprise Americans," Daly said in a Yahoo Finance interview. Indeed, the Nomura team called Bullard's remarks a "trial balloon" to see how markets would respond. "Markets have responded, but not in a way the Fed would consider 'disorderly,' " the firm said. "From the Fed's perspective, hiking multiple times by 75bp would bring them to neutral more quickly." Bank of America global economist Ethan Harris said the Bullard suggestion "makes sense," but he doesn't expect it will find support in May. "The Fed-induced rapid rise in interest rates may now put officials in more of a wait-and-see mode as they assess the degree of slowing, particularly in the housing market," added Citigroup economist Andrew Hollenhorst. "With demand still well above supply (particularly in the housing and labor markets), the risk is that even more hawkish interest rate policy (e.g. 75-basis-point hikes or a longer string of 50-basis-point hikes) will ultimately be pursued." Krishna Guha, the head of central bank strategy at Evercore ISI, advised clients, "Our message is don't panic. We think the likelihood of a 75bp move in May is still very low and we think the Fed will likely stick to 50s more broadly through June and July before reverting to 25s from September." However, he said the recent market gyrations represent a communication problem from the Fed. "In our view this episode exposes the problems arising from the Fed leadership's failure to put more of a framework and structure around the move towards larger units of hiking, and highlights the need for Powell to corral the debate not later than the May press conference," Guha wrote. "We think Chair Powell needs to break this dynamic and provide more structure around policy in general and the shift to 50s in particular."

U.S. Federal Reserve Chairman Jerome Powell addresses an online only news conference in a frame grab from U.S. Federal Reserve video broadcast from the Federal Reserve building in Washington, U.S., January 26, 2022.

U.S. Federal Reserve | via Reuters

Investors have dramatically changed their views on how quickly the Federal Reserve will raise interest rates in the coming months as the central bank tries to put out the inflation fire.