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Why the speed of impending Fed policy tightening could surprise

Senior Economist
Peter Hooper

In a new report Peter Hooper, Head of Global Economic Research, and Matthew Luzzetti, Chief US Economist, explain that in recent months the Fed has pivoted toward a more aggressive path of exiting from its current ultra-accommodative pandemic emergency policy stance. They highlight that their view has also become considerably more hawkish, with their baseline expecting liftoff in March, four total rate hikes this year, and a rapid drawdown in the balance sheet beginning in Q3. The central message of the note is that we could be in for an even bigger hawkish surprise in the months ahead.

The Fed now finds itself behind the curve as a result of a much faster than anticipated tightening of the labor market, strong increase in wage inflation, a huge overshoot of price inflation, and inflation expectations that could break out above desired levels. While there are still good reasons to expect many of these pressures to ease over the year ahead, there is also a growing risk that they will not, or at least not as quickly as is currently assumed.
To reduce the risk of unwanted momentum building into excessive inflation pressures, the Fed may need to return to a more neutral policy stance sooner rather than later. Monetary policy still works with long and variable lags, and events augur for the return to a more pre-emptive approach to setting policy to avoid the hard or harder landing down the road caused by having to deal with a more persistent inflation problem.
In addition to building the case that this hawkish scenario is a material risk to the outlook, the report also calibrates the possibly necessary monetary response, and details both the data that could push the Fed in this direction over the coming months and the most likely sequence of monetary policy actions.
Clients of Deutsche Bank Research can access the full report here.
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