The market expects Fed Funds to stand at 2.75% in December, up from 1% recently, and 2.86% by December 2023. Is this realistic?

A sharp increase in key rates this year is plausible because the Fed wants to close the gap with inflation. If the 250bp of tightening (from 0.25% to 2.75%) did occur, 2022 would then be the year marking the largest increase in the Fed Funds rate since 1994, when it advanced from 3% to 5.5%. Only the spectacular rises of the legendary Volcker era, between 1979 and the early 1980s, were of greater magnitude.

However, the current level of the real (i.e. inflation-adjusted) Fed Funds rate is -7.3%, the lowest level ever reached and leagues below the -0.7% level Volcker inherited when taking the helm at the Fed in August 1979. Between 1979 and 1984, the Fed was forced to maintain real policy rates between 5% and 8% to put paid to the runaway inflationary.

Although the inflation spike is probably behind us at 8.5% in March 2022, it may take longer than expected to recede due to its increasingly external origin, thus requiring the real Fed Funds rate to be at least equal to its long-term average of 1%. This would imply that the Fed’s tightening will continue at a solid pace in 2023, which could be highly disruptive to bond and equity markets.

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