In January 1994, with the economy several years into a recovery from the 1990-91 recession, Fed Fund futures priced a slow rise in U.S. interest rates. Investors expected rates to rise from 3% to perhaps around 4.25% by March 1995. The Fed, which was not yet engaged in managing market expectations, raised rates much more quickly than investors had anticipated and went much further, eventually raising rates to 6% by early 1995 before cutting them back to 5.25%. All told, the central bank went 175 basis points (bps) further than Fed Fund futures had anticipated at the outset of the tightening cycle (Figure 2).

Following the Asian Crisis, the Russian debt default and the meltdown of hedge fund Long-Term Capital Management, the Fed cut rates from 5.5% to 4.75% over the summer and early fall of 1998. While those events created substantial volatility in financial markets, they had little impact on the real economy, which continued to grow strongly. In June 1999, the Fed decided it was time to withdraw its monetary policy accommodation and began raising rates. Investors were largely caught off guard. Going into this tightening cycle, Fed Funds futures priced that the Fed might hike rates to 5% by the end of 1999 and maybe to 5.25% by mid-2000. Instead, the Fed went much further, raising rates to 6.5%, which was followed by the tech wreck recession in 2001 (Figure 3).

Between 2000 and 2002 the tech-heavy Nasdaq index fell by 85%, and business investment contracted sharply. To prevent a deeper recession Fed Chair Alan Greenspan slashed rates from 6.5% to 1% by June 2003 and left them there until June 2004. By this time the Fed had begun signalling its intentions more clearly than it had in the past. As such, markets were somewhat better prepared for the 2004 to 2006 tightening cycle. At the outset of the cycle, Fed Funds futures priced that the Fed was most likely to raise rates to 4% by mid-2006. Once again, they went substantially further opting for 17 consecutive rate hikes that brought Fed Funds to 5.25% --125bps more than investors had anticipated at the outset (Figure 4). 

By 2015, the Fed had become even more attuned to the idea of managing investor expectations. As such, the December 2015 rate hike came as no surprise to most investors. In this case, investors overestimated the Fed’s tightening in 2016, anticipating that they would have hiked rates twice more by November 2016. Instead, the Fed waited an entire year to do a second hike. In 2017 and 2018, however, the Fed hiked rates more quickly than investors expected eventually bringing its policy rate to 2.375%, about 75bps more than investors had anticipated at the outset of the cycle (Figure 5).

In every one of the past four tightening cycles, the Fed raised rates 75-175bps more than the market initially anticipated. The bigger surprises came in the 1990s when interest rates were higher, moved more quickly and the Fed wasn’t yet engaged in managing investor expectations.

So, with investors expecting 150bps of tightening over the next two years, are they once again underestimating how far the Fed might eventually go?  With inflation at 7% and unemployment below 4%, the possibility that the Fed might tighten further than investors currently anticipate seems very real. Even so, there are counter arguments:

• Fiscal policy will likely become much tighter as Congress appears unlikely to approve legislation for additional spending.
• An equity market correction might limit the degree to which the Fed might tighten.
• High levels of debt and leverage might make the U.S. economy more sensitive to rate hikes than it was in the past.
• The Fed might not want to invert the yield curve for fear of triggering a recession. Currently, 10Y yields are well below 2%. So, taking short-term rates higher than investors currently expect might depend on 10Y rates rising, which may be part of the Fed’s goal in shrinking its balance sheet.

Even so, the past four tightening cycles occurred during periods of relatively slow-paced declines in unemployment and periods of low and stable inflation. Going into what investors believe will be another tightening cycle beginning as soon as March 2022, the U.S. economy appears white hot, and that might be increasing the upside risks for rates relative to investor expectations.