The Federal Reserve raised its benchmark interest rate by 25 basis points this week. The central bank also signaled that it’s likely to keep raising rates at every meeting well into the second half of the year, and made it clear that it will start paring its balance sheet soon.

If all this sounds quite hawkish, it should—at least stacked up against the Fed’s previous forecasts in December. Since then, inflation has intensified and become more deeply entrenched, and the market had already adjusted its expectations ahead of the Fed meeting. So, while the March information was a bit more hawkish than anticipated, it wasn’t a paradigm change.

The US Economy Should Withstand Rate Hikes

The Ukraine war is foremost among today’s uncertainties, and it’s simply too early for the Fed—or anyone else—to have a clear picture of the longer-term impacts. The Fed’s statement, and Chair Powell’s comments about the war, were largely factual—not predictive.

Powell simply noted that the war would likely push inflation up and economic growth down, which we agree is the likely outcome. The Fed will wait to see the balance between those two outcomes before deciding if the war necessitates a change to its economic outlook—and thus its policy outlook.

Inflation: More Severe and Embedded than Initially Thought

Even without the war’s impact, the Fed’s expectations on inflation and growth have shifted since the last forecast round. Inflation is more intense and deeply embedded in the US economy than the central bank had thought, and the central bank was compelled to boost its inflation forecasts. Meanwhile, persistent inflation is eroding purchasing power, resulting in a downgrade to economic growth forecasts.

The Fed upped its 2022 forecast for core personal consumption expenditures, its go-to inflation measure, to 4.1% from 2.7%, and increased the 2023 and 2024 forecasts—it now doesn’t expect inflation to fall back to 2.0% until at least 2025. The forecast for 2022 economic growth was cut from 4.0% to 2.8%, reflecting deteriorating real purchasing power made worse by surging commodities costs. If energy prices move meaningfully from here, inflation and growth forecasts will need to be revised.

The Fed made clear how it expects to respond to higher prices and lower growth: with tighter monetary policy. Based on the central bank’s new “dot plot,” most members of the Federal Open Market Committee (FOMC) expect rate hikes at each of the six remaining 2022 meetings. Several FOMC members expect at least one rate hike of 50 basis points or more at a single meeting.

A Rapid Evolution in the Fed’s Rate Path

The Fed has come a long way on its rate trajectory in a short amount of time. The most dovish of this week’s dots—each FOMC member’s estimate of year-end rates—calls for four more rate hikes from the central bank this year. That estimate would have been the most hawkish only three months ago.

Based on the new dot plot, potential outcomes for 2022 fed funds target rates ranges from 1.375%, meaning 100 more basis points of rate hikes, to 3.125% (evidently, one FOMC member believes that 275 basis points of additional rate hikes over the next six meetings is appropriate). A substantial minority of dots (seven of 16) call for more than 2% in rate hikes during 2022, meaning that seven of the 16 FOMC members expect to raise rates by 50 basis points at least one time this year.

Our Forecasts Reflect More Rate Hikes to Come

In large part because of the war, economic uncertainty is exceptionally high right now, making forecasts beyond the immediate future more challenging than usual. Our forecast, and any other, depends a lot on developments in Ukraine and associated moves in commodity prices.

Based on the information available today, we expect the Fed to raise rates by another 25 basis points in May, and to announce at that meeting that balance-sheet reduction will start. After that, we think another 125 basis points of hikes are likely this year, with at least one hike (probably June’s) of 50 basis points. Tightening should slow, but not stop, economic growth, allowing the Fed to slow the pace of rate hikes in the fourth quarter and into 2023–2024 and bring inflation gradually back to target.

We find it interesting that the Fed is explicitly considering balance-sheet runoff as part of its policy tightening tool kit. This suggests that the pace of the runoff itself could be flexible; if the Fed thinks balance-sheet reduction is a substitute for rate hikes, it might become desirable to use that tool more dynamically. Such an approach would be a big change from the last cycle, when balance-sheet reduction was meant to happen in the background.