As was widely expected, the U.S. Federal Reserve raised the fed funds rate by 25 basis points (bps) at its March meeting and strongly signaled more hikes to come given a tight labor market and surging inflation. The Fed also released a new Summary of Economic Projections, which shows large upward revisions to the inflation outlook and a significant corresponding pull-forward of more rate hikes into 2022 and 2023.

The outbreak of war in Europe has made a difficult balancing act even more challenging for Fed policymakers as they weigh an uncertain growth outlook against another jump in inflation. However, the Fed signaled that it thinks inflation risks materially outweigh the downside risks to growth, and as a result we expect the Fed to continue its path toward higher rates and a smaller balance sheet. The Fed would likely need to see significant economic slowing and market dysfunction before shifting from its hiking path, as higher and more broad-based price increases further raise the risk that inflation expectations become unanchored. While elevated inflation risks justify a tighter stance of monetary policy, a faster pace of rate hikes will likely weigh on growth over time as financial conditions tighten more abruptly.

Hawkish tone sets stage for further tightening

Along with the expected policy rate hike, the Fed conveyed an overall hawkish tone in the March FOMC statement and economic projections, as well as in Chair Jerome Powell’s press conference, by making several key changes. First, the Fed added forward guidance to the statement, noting that “ongoing further increases” of the Fed funds rate as well as a reduction in the balance sheet were likely. Second, the Fed had major revisions to the March economic projections relative to the previous forecasts in December 2021. U.S. inflation noticeably outpaced consensus expectations, particularly in January, which combined with additional inflationary impulse from war in Europe, prompted Fed officials to upgrade their inflation forecasts for 2022 by more than 1 percentage point. Officials also penciled in more modest declines in inflation in 2023 and 2024, keeping inflation meaningfully above the Fed’s 2% target over the forecast horizon. (The Fed’s preferred inflation measure is PCE – personal consumption expenditures.)

Consistent with inflation no longer being expected to come back down to target in the forecast horizon and Fed officials seeing inflation pressures as broader based, officials sharply revised their interest rate forecasts higher, and most now expect policy to be above neutral by the end of next year. The median forecast is now for a 1.875% fed funds rate at the end of 2022 (versus 0.875% forecast in December) and 2.750% at the end of 2023 (versus 1.625% previously). Of note, the dot plot shows most officials are forecasting rates somewhat above their median estimate of neutral of 2.4%, suggesting that Fed officials think policy needs to be at least somewhat contractionary to bring inflation back to target.

At the press conference, Chair Powell offered background on these hawkish forecasts while he also sought to preserve optionality to change the policy path as needed in the weeks and months ahead. Similar to his comments earlier this year, Chair Powell did not take the possibility of larger rate increases off the table.

Balance sheet runoff

After the Fed concluded its asset purchase program earlier in the month, Chair Powell confirmed our expectations that an earlier and faster start to balance sheet runoff relative to the past cycle will likely be announced at one of the next two meetings. A smaller balance sheet would also contribute to monetary policy tightening this year, and Chair Powell suggested that many officials saw balance sheet runoff as equivalent to an additional rate hike.

Risks to the outlook

Looking beyond the March meeting, we expect higher inflation and concerns about inflation expectations to continue to weigh more heavily on Fed officials than downside risks to growth in the coming months. As a result, our baseline forecast remains that there will be rate hikes at consecutive Fed meetings and a meaningful further tightening of policy throughout the year. This faster pace of tightening raises the risk of a hard landing further down the road and suggests a higher risk of a recession over the next 2 years.