The hottest inflation in four decades will force the Federal Reserve to take such extreme actions to tame prices that policymakers advertently drag the U.S. economy into a deep recession, according to Bank of America analysts.
In a Friday note, the bank's strategists said market pricing suggests inflation will fall to or below the Fed's 2% target within the next two years – but that a major economic downturn is needed in order for that to happen.
"What seems to be forgotten here is that inflation is a sticky, slow moving variable," the analysts led by Ethan Harris wrote. "Spikes can reverse quickly, but underlying inflation tends to move in a gradual lagged fashion with respect to the economy. It is going to take time to cool off the labor market and even more time to lower labor cost-driven inflation."
The analysts added that inflation expectations – which hit another 11-year high on Monday, according to a New York Federal Reserve study – could take some time to moderate. A steeper-than-expected increase in inflation expectations in May actually prompted Fed officials to approve the first 75-basis point interest rate hike since 1994 on fears that higher prices were becoming entrenched.
"The market is not a good gauge of inflation expectations for 'real people' and investors have an oversimplified view of the link between growth and inflation," Harris wrote. "In our view, it is going to be extremely hard for the Fed to get inflation back to target in a two-year time span."
The Bank of America analyst note comes just a few days before the release of new consumer price index data, which is expected to be another doozy: Economists surveyed by Refinitiv expect that inflation surged 8.8% in June on an annual basis, another 41-year high.
There are growing fears on Wall Street that the Fed will trigger a downturn as it raises interest rates at the fastest pace in three decades as it races to catch up with runaway inflation.
Fed policymakers in June approved a 75-basis point interest rate hike – the first since 1994 – pushing the federal funds target range to 1.5% to 1.75%. Another hike of that magnitude is on the table in July amid signs of stubbornly high inflation, Chairman Jerome Powell told reporters after the meeting, prompting investors to reassess the economic outlook.
Officials also laid out an aggressive path of rate increases for the remainder of the year. New economic projections released after the two-day meeting showed policymakers expect interest rates to hit 3.4% by the end of 2022, which would be the highest level since 2008.
Hiking interest rates tends to create higher rates on consumer and business loans, which slows the economy by forcing employers to cut back on spending. Mortgage rates are already approaching 6%, the highest since 2008, while some credit card issuers have ratcheted up their rates to 20%.
Harris previously estimated the odds of a recession next year are around 40%.
"Our worst fears around the Fed have been confirmed: They fell way behind the curve and are now playing a dangerous game of catch up," he wrote last month. "We look for GDP growth to slow to almost zero, inflation to settle at around 3% and the Fed to hike rates above 4%."