This Wednesday (5/4/2022), the Fed hiked rates by 50 basis points, and the market believes the Fed will hike interest rates to 3% and then halt. However, this appears quite unlikely based on past events, and we might be just a couple of steps away from a session.
This chart compares Fed Funds to CPI since 1998. Take a good look into what happens when the Fed begins to raise interest rates.
In the previous two rate hike cycles, the Fed did not stop hiking rates until Fed Funds exceeded CPI, where the real Fed Funds were therefore positive.
When the Federal Reserve responds to high inflation risks by increasing its benchmark federal funds rate, it effectively raises the level of risk-free reserves in the financial system, reducing the amount of money available to purchase riskier assets.
In contrast, when a central bank lowers its target interest rate, it essentially expands the money supply available for the purchase of risk assets.
Clearly, at this point, the Fed must increase the Fed Funds rate Much more than 3 percent for it to have a positive real yield. Inflation is likely to moderate at this rate, but it would have to go below 3 percent for the Fed Funds rate to have the same effect.
In conclusion, there is a chance that the Fed will have to go further than the market anticipates, which carries significant risks for asset markets and the whole economy, and some analysts at JP Morgan believe we will be experiencing a recession in the upcoming year.
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