Hedge fund mogul Bill Ackman tweeted a few days ago that the Fed should raise interest rates by 50 basis points in March.
Henry Kaufman, chief economist of Salomon Brothers, known as the "Doomsday Doctor," also noted in an interview with Bloomberg that if he was an adviser to Powell, he would urge the Fed chairman to take "drastic measures," starting with an immediate 50 basis point rate hike.
If the Fed does raise rates by 50 basis points in one fell swoop, it will be the Fed's most aggressive monetary policy tightening since May 2000.
Will the Fed really "hawk" to this extent?
Peter Hooper, head of global economic research at Deutsche Bank, and Matthew Luzzetti, chief U.S. economist, released a report on Tuesday saying the Fed could raise interest rates faster than expected, possibly even by 50 basis points at some stage.
A more positive shift
Deutsche Bank pointed to data that could trigger a more positive response from the Fed. Broadly speaking, data that demonstrates that inflationary pressures are becoming entrenched and that fed expectations of a faster price decline are being undermined by the new inflationary psychology are most important.
Specifically, data that could trigger a more positive Fed response in the coming months could include:
1. The Quarterly Growth rate of the Employment Cost Index (ECI) hit another ten-year high;
2. The month-on-month inflation data showed little sign of easing, especially when services inflation (e.g. rents and open exchange rates) was higher and inflation trend indicators were well above 3%;
3. Indicators of inflation expectations rose further, raising concerns about de-anchoring;
4. The labor market continued to decline, with the unemployment rate rapidly falling to a pre-pandemic five-decade low.
In Deutsche Bank's view, although items 1 and 4 are likely to happen, they will not touch the Fed's bottom line; instead, the Fed wants to see inflation ease, and inflation expectations do not continue to rise.
However, the current inflation risks are clear, with core CPI soaring to its highest level in nearly 40 years, U.S. University of Michigan consumer confidence falling in January, and inflation expectations hitting a 10-year high.
Deutsche Bank therefore believes that the Fed is likely to undergo a more positive shift in the coming months.
What would the more radical response look like in this case? Can the Fed raise rates at more than 25 basis points or consecutively at meetings? Could the balance sheet be used more aggressively to tighten financial conditions?
So, what are the most likely scenarios?
Two Deutsche Bank analysts said:
"The most likely scenario is that the Fed will raise rates at every meeting starting in March this year", "If the (inflation) data develops along this risk scenario and does not fade in the second half of the year, then there will be six or seven rate hikes this year"
In addition, according to Deutsche Bank, the Fed may decide to announce an early cut in the portfolio of Treasuries held, possibly starting at the March meeting as early as the March meeting and starting with quantitative tightening (QT) in the second quarter.
In addition to accelerating tightening, the Fed may not be more aggressive in using its balance sheet to tighten policy in this case.
Deutsche Bank explained that in the current environment, this measured pace may be able to avoid imbalances and thus achieve a "soft landing" without accumulating financial vulnerabilities.
It is worth mentioning that this will not allow the policy to return to neutrality before the end of the year, but it will not be too far from neutral. By the first half of 2023, even taking into account higher inflation rates, policy will be in the neutral range by then.
While such an approach would undoubtedly tighten financial conditions, Deutsche Bank believes it is desirable from the Fed's point of view.
The rationale is that this approach allows the Fed to learn more about the uncertainties associated with the outlook and the impact of its actions on financial markets, such as whether supply issues are being resolved, how accelerated balance sheet reductions affect markets, and whether the neutral federal funds rate is really as low as the market suggests.
Can Powell preemptively attack?
Deutsche Bank believes it is still possible for the Fed to enter the pattern of a more aggressive rate hike of the mid-1990s, which is a one-time 50 basis point hike.
In the mid-1990s, in order to curb inflation that was moving too fast, the Fed raised interest rates seven times in a row since the beginning of 1994, and the federal funds rate was raised from 3% to 6%, a rate hike of 300 basis points.
Since then, in order to curb the dot-com bubble, the Fed has raised interest rates six times since 1999, during which the federal funds rate has been raised from 4.75% to 6.5%, raising interest rates by 175 basis points.
During this period, greenspan, then chairman of the Federal Reserve, raised interest rates by a one-time 50 basis points or even 75 basis points during the period.
Can the current Fed Chairman Jerome Powell preemptively strike like Greenspan?
Deutsche Bank says this is less likely, with a 50 basis point rate hike requiring the following conditions:
1. There is clear evidence that inflation is off anchor and inflation data is not improving;
2. Long-term inflation expectations have risen sharply;
3. The labour market is becoming increasingly tight.
But it is still not impossible.
"The tightening cycle may be more aggressive than fed officials have suggested and what our own underlying assumptions contain, and the risk has clearly risen."
For the market, Tuesday's double-kill means that monetary policy has spread a lot more, and the Fed's anchor guidance for the yield curve may be ineffective.
On Tuesday, U.S. Treasury yields rose across the board, with the 10-year Treasury yield rising to 1.85 percent at one point, its highest level since January 2020. Stocks in Europe and the United States weakened, with S&P 500 futures extending their losses to 1 percent and NASDAQ futures falling more than 2 percent.
As Deutsche Bank concludes:
"The likelihood of the Fed triggering greater volatility has risen to its highest level since the mid-1990s."
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