When will the Fed declare victory?

THE defining feature of the first half of 2022, from a financial market perspective, has been the dramatic change to US interest rate expectations. This has led to both bond and equity markets posting significant losses across the board. A natural question, therefore, is when will the Fed declare victory. We are getting closer to that point, but given what is at stake, it will probably err on the side of caution for a little while longer.

At the end of 2021, the Fed was projecting that it would raise interest rates by 75 basis points (bps) in 2022. By March this year, this had risen to 175 bps, and by June to 325 bps. I have been professionally tracking the financial market for over 25 years and this is by far the most dramatic shift in expectations I have seen in a 6-month period.

At the theoretical level, one can question why the Fed should be responding to an inflationary problem that is largely supply-side driven and, by definition, is not something the Fed can address. The answer is that the Fed believes the risks of inflation expectations becoming entrenched, regardless of their cause, was just too great. Therefore, it was important that the market believed that the Fed was willing to drive the economy into a recession, if that is what was required, to bring inflation expectations lower.