The Federal Reserve is likely to hike rates more than markets now expect, said Ricardo Reis, an economist at the London School of Economics.
“Markets are getting shaken up,” Reis told MarketWatch on the sidelines of the American Economic Association’s annual meeting in New Orleans.
“All the risks are on the upside. A rate of 5.5% is the minimum,” he added.
Last month the Fed raised the upper end of its interest rate range to 4.5%. The central bank set a final interest rate of 5.25%.
Investors trading the Fed fund futures market now expect the Fed to stop raising rates when rates hit 5%.
Reis believes the central bank will eventually hike rates.
The Fed is burned for failing to recognize the continued upward movement in inflation in 2021, he said.
“So I think they tend to overtighten,” he said.
“Either for valid reasons or because they’re worried about fixing their past mistake, it’s going to be tighter than you think,” Reis said.
The economy is at an inflection point and the Fed faces some “tough challenges,” Reis said.
The key to the future is the path of wages.
Workers’ wages must rise because their paychecks have not kept pace with inflation.
So the Fed has to assess whether the wage increase is too high, just right or too little, he said.
Unless wages rise sharply, inflation can quickly return to the Fed’s 2% target, he said.
If wages rise in line with productivity, the Fed doesn’t need to raise too much and inflation will fall to 2% in a couple of years.
This becomes difficult as productivity is a difficult economic variable to measure.
If wages spike, it would likely result in companies raising prices further, setting in motion a wage-price spiral, Reis warned.
The Fed could overreact to the increase in wages, he said.
There is a scenario where interest rates rise “much more,” Reis said. But there is a range – it could be “much much more” or “much more” or “just more”.
Reis said he agrees with the idea that raising the unemployment rate to 5.5% isn’t a terrible outcome if it means a return to low inflation.
The unemployment rate reached 3.5% in December.
Stocks DJIA, +2.13% SPX, +2.28% rose sharply on Friday as the government reported relatively slow wage increases in December. The yield on the 10-year Treasury note TMUBMUSD10Y, 3.562% fell to 3.56%.