When, and to what degree, the Fed may raise rates

Josh: We’ve just revised our view on when the Fed will likely need to raise rates, from the second half of 2022 to the first half, perhaps as early as March. Wage inflation data will be important to that timing. We believe the Fed will initiate at least two quarter-point rate hikes in 2022, and that additional policy tightening will likely be warranted, either through a reduction in the Fed’s bond holdings or through one or two more policy rate increases.

Adam: The Fed will want to see in the January employment data what the Omicron wave has meant for the labor market. But the traditional definition of full employment, in its rawest sense, is that everyone who wants a job has one or can easily get one. By almost every labor market metric, we’re very close. There are still a couple of million unemployed people who say they want a job, and that cohort is about 600,000 larger than it was pre-COVID. That includes some who can be very selective in the job and wages they accept. We expect that cohort to contract quickly.

Josh: Our view is that, over the next few years, the Fed will ultimately need to raise rates to a level that restricts the economy sufficiently to contain inflation—by our estimates likely around 3%. That is roughly 100 basis points higher than where the market has been pricing.¹ Our view considers our estimate of the neutral rate and inflation around the Fed’s target level.²

The delicate position for the Fed is to tighten policy enough to moderate inflation pressures without doing so too aggressively and ending the business cycle prematurely. But being too easy at this point likely invites a greater risk. If the Fed were to lose control of inflation or inflation expectations, there’s a range of potential outcomes that could have negative effects on the real economy, the value of assets, and people’s standards of living. We expect these considerations to be part of Fed policy debates.