Will the Fed choose to raise interest rates by 50 basis points to curb inflation?

Will the Fed return to the "deterrent" tactics of sharp rate hikes adopted in the 1980s and 1990s to curb inflation? Or will it continue the caution of recent years?

As inflation hits its 40-year high, the federal funds rate will rise sharply by 0.5 percentage points in March. Hedge fund manager Bill Ackman tweeted over the weekend to urge such a strong action, as did Henry Kaufman, a 94-year-old former chief economist at Salomon Brothers.

According to the Chicago Mercantile Exchange Federal Watch website, the federal fund futures market has absorbed expectations for the Fed's four 25 basis point rate hikes this year. The Fed is expected to raise rates for the first time at the FoMC meeting on March 15-16 and again at its June 14-15 meeting. After that, there could be a third at the FOMC meeting on September 20-21 and a fourth at the December 13-14 meeting.

This is consistent with the Fed's gradual approach in the 21st century, which is designed to avoid catastrophe in financial markets after the previous sharp rate hikes. The last time the funds rate was raised by 0.5 percentage points was in May 2000, just before the dot-com bubble burst.

Prior to that, the Fed quickly raised interest rates sharply in 1994, including two 0.5 percentage point hikes and one 0.75 percentage point hike. The moves calmed rising inflation concerns, but also triggered some memorable financial market crashes. The U.S. Treasury and mortgage-backed markets were thrown into chaos by the Fed's rate hikes, followed by the bankruptcy of Orange County, California, where the company's speculation on interest rate derivatives failed. The collapse of the Mexican peso and the subsequent $50 billion bailout came to an end.

Even a quarter-century later, the Fed may not forget its experience in 1994, though its incremental approach has not prevented more severe financial market turmoil. In fact, some people think it helps them. From mid-2004 to mid-2006, the FoMC slowly and predictably raised interest rates by 25 basis points at each meeting, which arguably fueled the housing bubble. This led to the dramatic outbreak of the 2008-09 financial crisis.

Since then, the Fed has been vigilant against market crises, partly because of the impact of market crises on the real economy and partly because the Fed plays the role of regulator of the financial system. This was evident in the crisis situation caused by the Covid-19 pandemic in March 2020, which prompted the Fed to intervene in unprecedented ways, including access to corporate credit markets.

The Fed's sensitivity to market conditions is likely to be most pronounced in the fourth quarter of 2018. In October, Fed Chairman Jerome Powell announced that the Fed "has a long way to go" from neutral policy after raising the federal fund target range to 2%-2.25% at the end of September. It will raise rates again in December. But the S&P 500 stopped falling after a nearly 20 percent decline, the traditional definition of a bear market. After that, the S&P 500 no longer exercised restraint and cut rates three times in 2019.

For much of 2021, the Fed has maintained a hyper-stimulus policy, maintaining its federal funds target rate at 0%-0.25% and buying $120 billion in Treasuries and mortgage-backed securities a month, but recently began to scale back its bond purchases. Meanwhile, several Fed officials have said they support the start of the rate hike process after the end of the march purchase of securities.

Four rate hikes are expected this year, each at 25 basis points, and financial markets are already feeling the trend. On Tuesday, the benchmark 10-year Treasury note yielded a high two-year yield of 1.87 percent. Yields on two-year Treasuries, where coupon rates are most sensitive to the Fed's future actions, exceeded 1 percent for the first time since before the pandemic.

Stocks continued their 2022 downward trend, with the S&P 500 down more than 4 percent from an all-time high and the Nasdaq composite nearing its correction range, down 9.5 percent from its peak last November.

But Goldman Sachs said it would need to do more to tighten financial conditions across all markets if the Fed wants to aggressively lower inflation instead of waiting for supply chain issues to ease. The company's economists wrote in a client note that the rise in bond yields has been offset by higher stock prices since the Fed hinted in September last year that the federal funds rate would rise.

Gregory and Getiri, macro strategists at the Bank of Montreal (BMO), said that as things stand, the Fed's current policy is the simplest since the mid-1970s, which is also the cause of the current high inflation.

Inflation may not have peaked yet, both in terms of overall and core (excluding food and energy) indicators. By mid-year, the consumer price index (CPI) is expected to fall to 5.6 percent from just 7 percent announced in December. They wrote in a research note that by then, relatively high inflation data when the economy reopened last year would be removed from the 12-month measure.

The disappearance of inflation while monetary policy remains accommodative is incredible, as evidenced by negative real interest rates (i.e., below price growth rates). If the Fed unexpectedly raises rates by 50 basis points, it would be shocking, but also awe-inspiring.

This article originated from the financial world