Three Reasons the Fed May Deliver a More Aggressive Tightening Cycle

The US Treasury market seems to believe the Federal Reserve will start hiking interest rates in the second half of 2022 with a relatively shallow path for rate hikes thereafter. Market pricing appears to imply that the Fed will raise rates by about 100-125 basis points (bps) in the two years following “liftoff.” That’s about half the pace and magnitude of the 2016-2018 tightening cycle, which was already slow by historical standards.

Why is the market projecting this low, slow rate path? The economic outlook is uncertain, and I believe this slower implied pace of hikes incorporates some probability that the tightening cycle is either delayed or derailed. However, if and when economic conditions meet the criteria for liftoff, I think this cycle has three distinctive features that could propel a faster pace and greater magnitude of tightening than the market seems to expect.

1) A deliberately late liftoff; abandoning pursuit of the elusive “soft landing”

In previous cycles, the Fed began tightening in anticipation of achieving its economic objectives. This preemptive approach targeted a “soft landing”—growth moderating toward trend levels while the Fed gradually nudged up interest rates to a more neutral setting. In this cycle, the Fed has explicitly committed to keeping interest rates pinned near zero until its employment and inflation objectives have been achieved. But I believe this approach, designed to let inflation run hotter, could make it difficult for the Fed to act gradually if and when it starts to tighten.

It’s worth noting that Fed Chair Jerome Powell recently suggested that the timeline for tapering asset purchases this time around could be shorter than in previous cycles. He noted, “The economy is much farther along than it was when we tapered in 2013."i It’s not hard to imagine similar messaging around the rate path when the Fed starts preparing for liftoff.