The Fed raised its benchmark interest rate by 75 basis points yesterday, to a range between 1.50% and 1.75%, and signaled stronger inflation-fighting measures ahead. We think that policy path will eventually cool inflation—but at a greater cost to economic growth than the Fed expects. And financial markets will likely stay volatile for a while.

Fed Chair Jerome Powell had earlier indicated a likely 50 basis point June hike, but media reports had increasingly pointed to a 75-point hike—and markets priced in the more aggressive outcome. The central bank leader cited recent inflation numbers and rising inflation expectations as drivers of the bigger move. Powell noted that the size of future hikes would depend on incoming information, though he expects a hike of 50 or 75 basis points will likely be appropriate in July.

The Fed Is Serious About This Inflation Battle

The central bank’s actions and statements demonstrate an intensified focus on getting inflation under control. Based on the median forecast in its “dot plot,” the Federal Open Market Committee (FOMC) expects another 1.75% in rate hikes this year, raising the target rate to 3.25%–3.50%.

That’s 150 basis points higher than was expected based on the March dot plot. The committee also upgraded its median expected terminal rate to 3.75%–4.0%, 100 basis points above March’s forecast. The Fed is clearly rattled by the breadth, magnitude and persistence of inflation and expects to respond accordingly, pushing policy into restrictive territory to slow demand.

Powell emphasized that the Fed’s first priority is cooling inflation. He kicked off the post-meeting press conference by calling inflation “far too high,” observing that the FOMC had expected it to be moving sideways or lower by now. Because it isn’t, the policy moves were more aggressive. Inflation will be priority one until the Fed gathers “compelling evidence”—a series of data releases showing decelerating inflation. At that point, the Fed would likely pivot toward a more balanced focus on its dual growth-inflation mandate. Until then, the sights are on inflation.

More Hikes Ahead—with Inflation Expectations a Pressure Point

A July hike of 50 or 75 basis points would raise the policy rate roughly to the Fed’s neutral estimate—giving it more “optionality” on future moves.

Essentially, Powell suggested there will be less urgency to act once reaching the neutral rate even if inflation was still elevated. That tack sounds a bit dovish, since rates could be at neutral as soon as next month. However, the state of the dot plot and the Fed’s requirement for a series of favorable data releases make it less so. Optionality or no optionality, the Fed will keep hiking for the time being.

Powell hammered home that inflation expectations are a key pressure point for the Fed. He specifically referenced the University of Michigan’s inflation expectations gauge and the US Federal Reserve Board’s Index of Common Inflation Expectations as reasons for the more aggressive than expected June hikes. Powell made it clear that any upward drift in expectations will likely trigger even more tightening.

Economic Growth Will Show the Cost of Fighting Inflation

A steeper, more front-loaded tightening cycle makes economic growth likely to cool faster and more deeply than previously thought. The Fed’s median growth forecast for gross domestic product in both 2022 and 2023 (in Q4/Q4 terms) is 1.7%. That rate is 0.1% lower than the central bank’s estimate of the longer-run potential growth rate. And it comes with higher unemployment: up from the current 3.6% to 3.7% at year end, 3.9% for 2023 and 4.1% for 2024.

Powell described the Fed’s forecast path as a “soft landing”: growth barely below potential, inflation coming under control and the labor market remaining strong. He acknowledged that such an outcome has become harder to achieve—and he’s right. What’s more, a soft landing increasingly relies on outside help—if the supply side of the economy doesn’t heal shortly, a soft landing seems implausible, and the supply side is beyond the Fed’s control. Absent supply-side healing, and if inflation doesn’t fall soon, the Fed must keep tightening the screws on the US economy—even as it weakens.

We expect economic growth to slow by more than the Fed anticipates. Given the tightening path the Fed has laid out, combined with our view that inflation won’t come down enough to give the Fed comfort for a while, we see more policy tightening ahead. Those moves will help bring inflation under control over the Fed’s time horizon—though it will come at the cost of a deeper growth slowdown and more volatility in capital markets.