Asset Allocation & Macro Research, Pictet Wealth Management.

Our central scenario is for the Fed to announced four quarter-point rate hikes by summer before marking a pause. Reduction of its balance sheet could start in June.

We expect the Federal Reserve (Fed) to be undeterred by the current heightened global geopolitical tensions and hike rates by 25 basis points (bps) at its meeting on 16 March.

We still expect 100bps of tightening in total in 2022, but we now believe the hikes to be more front-loaded than in our previous scenario. We think the Fed will hike by 25bps at each Federal Open Market Committee (FOMC) meeting up to July. But then we expect the Fed to pause rather than keep increasing rates once per quarter until the end of the year.

Two developments could warrant a pause over the summer: first, it should be clearer by then that the covid-19 fiscal stimulus has waned, especially given that Congress seems reluctant to top it up, and the high consumer spending we are currently seeing could have moderated by that stage. Second, the economy should by then be feeling the effects of the rise in bond yields caused by the Fed’s hawkish policy turn since the end of last year. We believe the move in yields should be enough to absorb the current excess demand in the economy and slow down inflation. As such, we do not think, from a fundamental perspective, that further Fed hawkishness would be warranted.

The Fed is also preparing to reduce the size of its balance sheet by letting some bonds mature without reinvestment (‘passive’ shrinkage); the Fed still seems reluctant to actively sell its bond holdings. We think a decision on reducing its balance sheet could be taken at the June FOMC meeting.

An alternative scenario (but not our central one) would be that we see a ‘Volcker moment’—in other words, a return to more drastic policy action of the sort Chairman Paul Volcker undertook in the early 1980s). This scenario would mean the Fed would start to adopt a more ‘automatic’ Taylor Rule linked to the current high rate of inflation rather than based on inflation expectations and inflation forecasts for 2023. This implies there could be several consecutive rate hikes of 50bps each. There has not been such a big one-off hike since May 2000. We do not think such a scenario is likely unless there is a big surprise in Q2 wage data (once Omicron fades) and the Fed genuinely fears it needs to act forcefully to break a potential wage-price spiral.