Lindsay and Ann Saphir (NYSE:) Dunsmuir

(Reuters) -The unexpectedly large jump in U.S. consumer prices https://www.reuters.com/business/us-consumer-prices-rise-strongly-january-weekly-jobless-claims-fall-2022-02-10 last month has bolstered the view that the Federal Reserve is late to the fight against the strongest inflation since the early 1980s and needs to take dramatic action to make up lost ground.

Investors are betting that the U.S. central banking will begin with a 50-basis point interest rate increase at its March 15-16 policy conference. This is causing heated debate within the Fed.

Up until this point, Fed policymakers have largely rejected the idea. “I don’t think there’s any compelling case to start with a 50-basis-point” rate increase, Cleveland Fed President Loretta Mester, often among the Fed’s more hawkish voices, said on Wednesday https://www.reuters.com/business/feds-mester-says-case-half-percentage-point-rate-hike-march-not-compelling-2022-02-09,

The latest U.S. Inflation reading seems to have turned that upside down. Household prices were up 7.5% https://www.reuters.com/business/us-consumer-prices-rise-strongly-january-weekly-jobless-claims-fall-2022-02-10 in the 12 months through January, the Labor Department reported earlier on Thursday.

Just a few hours later, James Bullard, the St. Louis Fed president – who had last week agreed with Mester’s views – said to Bloomberg News that he was becoming “dramatically more hawkish” and asked for an entire percentage point of rate increases over the Fed’s three next meetings in March, May, and June.

Market participants had already begun pricing a bigger likelihood of a half-percentage-point rate hike in March on the back of the inflation data, up from a one-in-four probability when Mester spoke.

After Bullard’s bombshell they finished the job: bets are fully on a half-percentage-point hike next month and then some, with rates expected to be in the 1%-1.25% range by June and 1.75%-2.00% by the end of the year.

Fed policymakers indicated at their March meeting that they intend to raise the overnight benchmark interest rate by near zero. It will happen just days after the bank stopped its two-year run of purchasing trillions in government bonds per month. The central bank began bond purchases in order to maintain financial stability and encourage borrowing during the COVID-19 epidemic.

They are late by many measures, with inflation at an all-time high and the labor market tightening at odds with the Fed’s recent decision to end crisis-era support.

Karim Basta (chief economist, III Capital Management) says that all this supports a move of 50 basis points in March. It remains to be seen if the Fed will abandon its gradualist approach.

Mark Cabana is Head of U.S. Interest rates Strategy, Bank of America (NYSE) Global Research. Market bets for a higher March rate rise continue to grow.

“The logic is compelling for them to move,” he stated, noting the fact that this would bring Fed policy closer to the point of inflation while still keeping borrowing costs far lower than the levels where they might put an end to economic growth.

“Are your going to tell market that the market is wrong and they need to move slower?” Cabana said. We don’t believe the Fed will deny the market the right to choose if the market does not give it the opportunity.

At the Economic Society Deutsche Bank (DE) Thursday’s statement by the Fed said that they think it will start its tightening process next month with an increase of 50basis points.

Still, many economists for now are predicting the U.S. central bank will stick to quarter-percentage-point increments for future rate increases.

They claim that the Fed won’t increase the size of its rate increases to begin, but will instead speed them up faster than the quarter-per-quarter pace they have been following in recent history. Or, it might reduce its balance sheets sooner than anticipated.

Fed officials will closely monitor the data, as they are due to release more data on jobs and inflation before March’s meeting.

BOXED IN

Fed’s skepticism about disturbing financial markets is a concern. These have needed careful handling in recent years to keep from a knee-jerk tightening and repeated episodes like “taper tantrum 2013” which were widely viewed as communication errors.

A half-percentage-point hike in March wouldn’t itself hurt the economy, economists say, but the signal it sends about the future path of policy could if traders expect similar-sized increases in rates at future meetings.

“The market goes from pricing five (quarter-percentage-point rate hikes) to pricing eight, 10 and then you are potentially causing some real sharpening in financial conditions,” said Aneta Markowska, chief financial economist at Jefferies.

Markowska said that they are “way behind the curve” and “have a lot to catch up.” “But I believe it makes sense to make progress, not slowing down, but not aggressively.”

Rate hikes should be kept to 25 basis points increments so that the Fed can better adapt policy to data in the event of inflation cooling off, which Atlanta Fed President Raphael Bostic stated earlier this week.

Fed officials had been betting that the inflation spike would recede in the second quarter of 2015 as supply chains untangle and a COVID-19 epidemic eases, which will allow more people to go back to work. This makes a larger rate increase less necessary.

The Fed has already seen a significant tightening of the financial environment in the last few months, which means that there’s less work to catch up, despite the obvious disconnect between maintaining its policy rate close to zero and inflation at over twice the target of 2%.

A way to gauge tightening in monetary policy is to use the Wu-Xia “shadow” rate. This uses yields from bonds and other market indicators to indicate how loose monetary policy is, when the actual rate of policy is near zero.

The Fed’s $120 billion monthly purchase of Treasuries (and mortgage-backed securities) by the Fed pushed the rate to negative 2% after the recession that was triggered by the pandemic. About 1.65 percentage point has been added to the rate since November, when Fed Chair Jerome Powell started signaling an earlier end to the bond buying program and a sooner start to rate rises.

Narayana Kocherlakota (an economics professor at Rochester) was not a fan of the central bank’s hardline approach to the crisis.

He said, “I believe going 50 now also places it on the table at every meeting going ahead… so that it expands optionality in a large and useful way.” Much-higher-than-expected inflation, he said, “deserves an aggressive response.”