Asset Allocation & Macro Research Pictet Wealth Management.

The rising level of anxiety felt by the Federal Reserve (Fed) about inflation will likely see it step up the pace of its rate hikes to +50 basis points (bp) when it communicates at the end of its policy meeting on 4 May. Such a rise would follow an initial +25bp rise in March.

The sharp rise in wage growth in the first quarter, and especially in the employment-cost index data, can only increase the agitation among Fed officials who fear an uncontrollable wage-price spiral. By contrast, the Fed will very probably ignore the -1.4% Q1 GDP print as surging imports (a drag on GDP) masked strong underlying domestic demand. In fact, booming imports of consumer goods are a sign precisely of ‘excess demand’ that needs to be urgently curtailed—or at least that’s likely to be the Fed’s interpretation.

The Fed is also likely to announce the beginning of the passive shrinkage of its balance sheet by not reinvesting a portion of maturing debt on its books. The Fed has already signalled it targets a cruise speed of -USD95 bn per month for its nearly USD9 trn balance sheet.

The Fed does not have the luxury of policy finesse when annual headline inflation is above 8%. Still, sharper tightening, and the Fed’s very hawkish rhetoric about future rate hikes, come against a backdrop of fiscal-policy retrenchment and rising global macroeconomic and geopolitical risks. This could mean an abrupt deceleration in the US economy is in the offing over the summer, with housing acting as the canary in the coal mine. Our main scenario is a pause in tightening after summer as both inflation momentum and economic growth slow. At that stage, the Fed could turn back to its ‘natural’ preference for smoothing the US business cycle and avoiding triggering major debt sustainability problems and a recession.

As a reminder, we look for US growth to be below potential (below c. 2% annualised) in the second half of this year and in 2023. The economy could be especially vulnerable to outside shocks if geopolitical headwinds mount further.

Our Fed scenario is therefore +50bp in May, +50bp in June, a step-down to +25bp in July, and then a long pause before its potentially resumes hiking in early 2023. But the risk is that there is no pause and the Fed barrels through its tightening with more than two 50bps hikes. This alternative scenario will crucially depend on wage growth, in our view.