Market expectations for rate hikes are overly hawkish and central banks will end up living with some inflation in order to keep their economies growing, BlackRock says

• Central banks have primed markets to be too hawkish about rate hikes, said BlackRock Investment Institute.
• A euro-area recession is likely to prompt the ECB to pause rate hikes after taking its key rate out of negative territory.

Policy makers at the Federal Reserve and the European Central Bank may turn out to be less aggressive in hiking interest rates than investors anticipate, but the market will remain on edge as central banks look to fight inflation.

That's according to BlackRock, which says central bankers will likely opt to contend with higher inflation rather than heavily tamping down economic growth, according to BlackRock. Yet, even as the Fed and the ECB could end up being less aggressive in relation to other periods of monetary policy tightening, investors will continue to nervously expect a heavy handed response to combat inflation.

"The sum total of rate hikes will ultimately prove to be historically low, we believe, as central banks choose to live with inflation rather than squash growth. The problem: Markets have been primed to assume hawkish intent and are quick to perceive risks of overtightening. This keeps us neutral on equities in the short run," Jean Biovin, head of the BlackRock Investment Institute, wrote in a weekly commentary.

The ECB at its Thursday meeting in the Netherlands is expected to indicate it's set to start increasing its benchmark rate in the second half of 2022. ECB President Christine Lagarde last month said the eurozone was at a "turning point" on interest rates and in a blog post on the ECB's website wrote that the bank looked set to pull rates up from its current negative 0.5% level.

The Federal Reserve on June 15 is expected to raise its key rate by another 50 basis points, adding to the increase of 75 basis points since March. Another move this month would bring the fed funds rate to a range of 1.25%-1.5%.

The Fed is seen to reach peak rates at the end of 2022, BlackRock Investment Institute said Monday.

Consumer price inflation in the US and the eurozone is registering hot, with a near-record high of 8.3% in April in the US and a record high of 8.1% in the ECB's domain. Euro-area inflation is driven primarily by higher energy and food bills made worse by Russia's war against Ukraine.

"This should dissipate in the medium term, in our view, as Europe finds new energy and food sources," said BlackRock. US inflation is more broad-based, with increases almost equally driven by goods and energy prices. US inflation will likely be persistent and settle at levels higher than pre-Covid era, it said.

BlackRock said in both regions, production constraints ranging from supply bottlenecks to transportation to staffing have become the dominant drivers of inflation.

"The Fed and the ECB have yet to acknowledge the sharp trade-off when trying to rein in this type of inflation with rate hikes: Squash growth and jobs or live with higher inflation than before the pandemic," said the institute. "We don't see a goldilocks outcome where inflation stays near 2% while unemployment remains low and growth resumes an upward trend."

That leaves the door open for markets to expect overtightening at signs of persistent inflation, a tight labor market or economic strength – keeping BlackRock neutral on equities.

Markets expect the ECB to hike rates into 2023 but BlackRock foresees it pulling rates quickly out of negative territory and then pausing in the face of a recession triggered by Europe's energy crisis.

"We are looking for signs that central banks acknowledge the trade-off of living with some inflation for the sake of preserving growth. We could see another sharp policy pivot in the coming months, this time a dovish one. This would be a catalyst to go back to overweight equities," said Boivin.