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The Fed is ready to raise rates by 50 bps, but what comes next?

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(Kitco News) - The Federal Reserve is on the cusp of embarking on its most aggressive tightening cycle in mor than two decades. The central bank is all but guaranteed to raise interest rates by 50 basis points on Wednesday.

This will be the first 50-basis point move since 2000, but you have to go all the way back to 1994 to find a time when the U.S. central bank was this hawkish.

Still, the lingering question for markets and investors is just how hawkish the Federal Reserve will be.

Although markets see a nearly 100% chance of a 50-basis point move Wednesday, economists and market analysts note that there is still a lot of uncertainty surrounding the impending decision. There are some expectations that the Federal Reserve could surprise markets with a 75-basis point move.

Some economists see a 20% chance of a more aggressive move. However, the CME's Fed WatchTool shows that markets see nearly a 100% chance of a 75-basis point move in June. Win Thin, Global Head of Currency Strategy at Brothers Brothers Harriman, noted that markets see interest rates rising to around 3.25% by the end of the year.

On top of the rise in interest rates, the Federal Reserve has also suggested that it would start reducing its balance sheet by $95 billion a month.

According to some economists, what stands out more than the Fed's current aggressive stance on interest rates is the pace at which it has accelerated its plans. Colin Cieszynski, chief market strategist at SIA Wealth Management, noted in an interview with Kitco News that in December, five months ago, markets expected interest rates to rise by 75 basis points throughout the entire year.

Hedge funds drop their bullish gold and silver bets ahead of Fed meeting - CFTC

"The Fed is so far behind the curve that they have painted themselves into a corner, and they are rushing to raise interest rates," he said.

The Federal Reserve has been forced to shift its stance as inflation pressure rises out of control, being driven by elevated food and energy costs. In March, the U.S. Consumer Price Index showed annual inflation increasing by 8.5%, the biggest jump in 40 years.

Last month at the International Monetary Fund spring meeting, Federal Reserve Chair Jerome Powell highlighted the economic risks if the central bank doesn't get inflation under control.

"Economies don't work without financial stability," he said during the panel discussion.

"In the U.S., we have had expectations that inflation would peak around this time and would come down over the course of next year. These expectations have been disappointed in the past, and so now we want to see actual progress," Powwll said. "It may be that the actual peak was in March, but we don't know that, and we won't count on that. We are also not going to count on help from supply-side healing. We are going to be raising rates and getting expeditiously to levels that are more neutral than actually tighten policy."

This aggressively hawkish stance from the Federal Reserve has played havoc with financial markets. Last month the S&P 500 fell nearly 5.5% as markets started pricing in a 50-basis point move, which drove bond yields to their highest level since 2018.

The precious metals market, while fairing better than equities, has also seen significant volatility as the Federal Reserve set the stage for Wednesday's monetary policy decision. Last month gold prices lost nearly 2%, with prices trapped below $2,000 an ounce.

Monday, gold prices fell to a 2.5-month low as investors liquidated bullish bets ahead of the Federal Reserve's monetary policy decision. While gold has struggled, many market analysts have noted that historically gold has marked a long-term low at the start of the U.S. central bank's tightening cycle.

Some commodity analysts have noted that gold remains a substantial risk and inflation hedge as the Federal Reserve's aggressive positioning has increased the risk of stagflation or even a recession.

In a recent note, Huw Roberts, head of analytics at Quant Insight, said that gold is an undervalued safe-haven asset in the current market environment.

"The influential drivers of gold are risk appetite & credit spreads," Roberts said. "The long-term model emphasizes gold's role as a safe haven play – risk-off & wider credit spreads equate to higher gold. Today's levels of inflation removes government bond's role as an effective haven. A world characterized by uncertainty & price pressures, arguably make gold a more effective hedge than U.S. Treasuries."

While many economists don't see a recession as a base-case scenario, they have said that the threat is elevated as the Fed starts to tighten interest rates aggressively.

Some economists have noted similarities between the current tightening cycle and the last time the U.S. central bank was this aggressive nearly 30 years ago. In 1994 the Federal Reserve raised interest rates by 50 basis points twice and then a third rate hike of 75 basis points. That year, the central bank doubled interest rates to 6% in seven rapid-fire hikes. However, by 1995 the Central bank had to sharply reverse course and cut interest rates.

Sal Guatieri, senior economist at BMO Capital Markets, said that the Fed's monetary policy is the biggest risk to the economy.

"A recession is not our base-case view, but given the large number of things that could go wrong—persistent high inflation, even higher interest rates, conflict spreading beyond Ukraine's borders, extended lockdowns in China, and a more severe strain of the virus—the economy's resilience could be tested," he said.

The threat of an economic slowdown increased sharply last week after U.S. GDP data showed that the economy contracted 1.4% in the first quarter of 2022, significantly missing expectations. Many economists dismissed the disappointing report noted that a lot of the weakness was due to trade imbalances. However, other economists note that rising inflation is starting to weigh on consumption, which will be a drag on activity.

Avery Shenfeld, senior economist at CIBC, compared the Fed's challenge on monetary policy to landing a jet on an aircraft carrier: "the margin of error is tight."

For many economists, inflation will be the key to whether or not the Fed can achieve a soft-landing.

"There's still reason to hope that it's doable, because lower inflation late this year or in early 2023 will give the green light for the Fed to slow the pace of rate hikes. Pilots landing on aircraft carriers don't come in a full speed, and that's what the Fed will need to do to hit its mark after zooming ahead on rate hikes in 2022," Shenfeld said.

Kristina Hooper, chief global market strategist at Invesco, said that when looking at inflation, picking the peak is less important than the overall trend. She noted that a sharp decline in inflation would be the best-case scenario for the U.S. central bank. However, she added it is unlikely to happen.

"I expect inflation to remain at an elevated level for some time — I would anticipate headline US CPI to still be modestly above 5% by year-end given continued pressures. That's because the war in Ukraine has seriously impacted prices and supply chains," she said.

Hooper added that elevated inflation will force the Federal Reserve to follow its aggressive path, at least for now.

"In the next four to six months, I believe the Fed will be desperate to play catch up because it perceives itself to be well behind the curve. After that initial burst of tightening, I expect the Fed to become more moderate in its rate hikes — if the data offers the opportunity to do that," she said.

Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Metals Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Metals Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in commodities, securities or other financial instruments. Kitco Metals Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.