The Federal Reserve faces its most perilous policy challenge in decades as it attempts to cool rampant inflation without tipping the economy into recession. After keeping interest rates near zero through the pandemic, the Fed has pivoted aggressively with a succession of jumbo rate hikes. However, taming prices without severely hampering growth will require stellar precision. Each decision carries high stakes given fragile sentiment. Markets and the economy have reacted violently to monetary moves so far, underscoring the Fed’s tightrope walk ahead.

In March 2022, the Fed initiated its tightening cycle by raising its benchmark federal funds rate 0.25%. At the time, inflation had surged to 7.9% annually amid pandemic supply constraints and massive stimulus spending. But Russia’s invasion of Ukraine soon sent energy and food costs soaring globally, pushing US inflation above 9% by June – the highest since 1981.

Spooked by runaway prices, the Fed embarked on supersized 0.75 percentage point hikes in June, July and September – triple the standard increment. Rates now stand at 3-3.25%, with markets expecting them to reach 4-4.5% by early 2023. The Fed hopes sharply limiting money supply growth will dampen demand enough to align it with constrained output.

So far, the economy has proven resilient with unemployment at 3.5% and growth positive. But each rate hike has roiled markets as investors weigh risks of fueled volatility and fragile sentiment derailing growth.

After the September hike, stocks plunged into a bear market with the S&P 500 falling over 25% on the year. Higher mortgage rates have also started biting the housing sector with permits and starts dropping. “The Fed is trying to engineer a soft landing, but risks abound,” noted Torsten Slok, chief economist at Apollo Global Management.

Critics argue the Fed reacted too slowly, allowing inflation to become entrenched before hitting the brakes. However, others counter an earlier aggressive tightening may have needlessly harmed the economy when supply-driven inflation was partly beyond the Fed’s control.

“Chastising the Fed for not acting faster seems misguided given the tremendous uncertainty at the time regarding supply dynamics,” said UBS economist Jonathan Golub.

Nonetheless, the Fed must now walk a tightrope to avoid overcorrecting. If it hikes too much, growth may crater while unemployment spikes. But if it under tightens, inflation may stay elevated. “There are risks from moving either too slowly or too rapidly,” warned Fed Chairman Jerome Powell.

Much depends on how inflation expectations and wage-price dynamics unfold in coming months. If households and businesses lose confidence in the Fed’s inflation-fighting commitment, a self-fulfilling wage-price spiral could take hold.

On the other hand, supply chain improvements and easing of pandemic distortions could provide inflation relief without requiring harsh Fed medicine. “Fundamentally anchored inflation expectations remain key,” said BlackRock Investment Institute strategist Wei Li.

Markets expect at least another 1.25 percentage points of tightening by early 2023. However, the pace and peak remain data-dependent. The Fed must tread carefully between the risks of runaway prices versus stunted growth.

Walking this balance beam has only become more precarious given heightened market sensitivity to Fed signaling. One modestly dovish or hawkish tilt can trigger outsized reactions across stocks, bonds and currencies. This forces Fed officials to choose their words more carefully than ever.

“The margin for policy error is exceedingly narrow,” said Mohammed El-Erian, chief economic adviser at Allianz. “The Fed must craft an orderly slowdown without financial instability and recession.”

While the Fed’s path ahead is challenging, its credibility and policy flexibility on rates and balance sheet tools offer room to stick the landing. But as the economy slows in the coming quarters, volatility and uncertainty seem guaranteed. Markets remain on high alert surrounding each Fed decision and communication. After a remarkable 18-month transformation, this former dove now relies on steady hands and superb judgment to restore stability.

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