By the end of 2022, the Federal Reserve is expected to lift its benchmark federal funds rate to a level it has not reached since 2008. Many market watchers, however, fear that such a drastic rise could exacerbate a potential recession while not doing enough to combat roaring inflation.

The Fed, which dropped rates to near zero in March 2020 in order to combat the economic effects of the pandemic, has pushed interest rates up 225 basis points since March. Fed Chairman Jerome Powell and other Fed officials have said the central bank will continue to boost rates until inflation, which has climbed to highs not seen since the early 1980s, is reined in.

Few expect the Fed to increase rates much beyond another 100 basis points; the futures market is increasingly betting on rate cuts within a year. Central bankers will then be in a precarious position where increased rates could help push the U.S. into recession but fail to curb runaway inflation. The latest employment data compounds the problem.

Nonfarm payroll employment rose by 528,000 in July, more than double economists' expectations, while unemployment dropped to 3.5%, from 3.6% in June, its lowest level since February 2020, the Bureau of Labor Statistics reported Aug. 5. The Fed's inability so far to cool the domestic labor market may compel Fed officials to hike rates more aggressively.

"The Fed is feeling its way through the current situation with no one sure about what will be the tipping point that could lead to a 'real' recession," said James Knightley, chief international economist with ING. "I don't think anyone knows what the end game will be."

Wishful thinking

Powell has said the Fed is committed to bringing inflation back to 2%, a daunting task considering the personal consumption expenditures price index — the Fed's preferred inflation metric — grew to 6.8% from June 2021 to June 2022, and the consumer price index — the market's preferred metric — reached 9.1%.

The Fed's primary tool for moderating inflation is increasing its target federal funds rate, the overnight rate at which banks lend and borrow excess reserves to each other. The rate, currently between 2.25% and 2.5%, has impacts across the economy, including significant influence on consumer loan and credit rates.

Powell has indicated the Fed plans to increase rates by another 100 basis points, to a target rate of 3.25% to 3.5% before the end of the year, with more possible into 2023 if inflation continues to climb. The market interpreted this as a dovish shift from the Fed, causing a modest rally in equities on the increased likelihood that rates could hold steady or even be cut next year.

Fed officials this week have attempted to counter this view. Mary Daly, president of the Federal Reserve Bank of San Francisco, said Aug. 2 that the central bank was "nowhere near" done with its fight against inflation.

"They are reinforcing the message that the Fed will prioritize fighting inflation over growth," said Michael Crook, chief investment officer at Mill Creek Capital Advisors. "The Fed is messaging that the market is too dovish and needs to reprice, but that message hasn't gotten across yet."

The majority of traders believe the target rate will top out at about 3.5%, according to the CME FedWatch Tool, which measures investor sentiment in the Fed funds futures market. But an increase of that size and a policy pivot within a year will likely not be enough to tame inflation, said Alfonso Peccatiello, author of The Macro Compass, a financial newsletter, and former head of investments at ING Germany.

"My guess is that 100 [basis points] might be on the conservative side, and also the time span for such restrictive rates is perhaps a bit longer than people expect if you want to succeed in fighting inflation," said Peccatiello. "In other words, a 'one-touch' hike to 3.5% with forwards already pricing cuts in 2023 might not be a sufficiently tight policy."

'A different ballgame'

The prospect of an easing in Fed monetary policy hinges on the wishful expectation that inflation will soon peak, said Zoltan Pozsar, global head of short-term interest rate strategy at Credit Suisse.

"This is a different ballgame," Pozsar wrote in an Aug. 1 client note. "If you think that the peak of tightening is 3.5% because inflation peaked … and that cuts are coming next year because a recession is nigh and stocks are now at the cusp of a bear market … you might be terribly wrong."

Boosting rates by 100 basis points will not be nearly enough to counter the impact that global supply chain issues and Russia's war in Ukraine have had on inflation, Pozsar argued. Rather than stopping at 3.5%, the chance of the Fed increasing rates to 5% or 6% — and dealing a significant blow to the economy — is "very real," he wrote.

Still, others believe that the central bankers will be reluctant to increase rates much beyond 3.5%, partly since so much of the rise in prices appears out of their control. The Fed is unlikely to increase rates if doing so will only drive the U.S. into a deeper recession.

"Hiking fed funds to 4%, 5% or higher won't make semiconductor factories in Asia run more consistently, nor will it deter the Chinese from future lockdowns," Tom Essaye, a trader and founder of financial research firm Sevens Report Research, wrote in an Aug. 2 note. "Part of the inflation problem is a lack of global supply of goods, and while decreasing demand via interest rates will ease price pressures, destroying demand completely will materially damage the economy, but it won't fix [the] supply issue."