The Fed is about to whack the economy and will be forced to slash interest rates sharply in 2023, traders predict

• Markets are flashing a warning: The Fed's quest to tame inflation will hit growth and force it to slash rates again.
• Traders shifted their expectations Wednesday, and now expect the Fed to cut interest rates by 50 basis points in 2023.

Financial markets are flashing a warning: The Federal Reserve's quest to tame inflation is going to whack economic growth within the year, and force the central bank to start slashing borrowing costs again in 2023.

Fed Chair Jerome Powell warned on Wednesday that although the US economy is strong, "there's no guarantee" the central bank can raise interest rates sharply to tackle inflation without derailing growth.

"The process is highly likely to involve some pain," he said at a European Central Bank conference in Sintra, Portugal.

Bond market traders were quick to respond. They expect the Fed to hike interest rates to a peak above 3.5% in March 2023 as it tries to bring down inflation, according to the prices of futures contracts listed by Bloomberg.

But as of Thursday, traders expect the US central bank to have to start cutting interest rates in the middle of 2023 as growth slows, slashing them by around 50 basis points to roughly 3% by December of next year.

Only a week earlier, the market expected the Fed's main interest rate to stand at around 3.2% by the end of 2023.

"The great and good at the ECB's Sintra conference have made it pretty clear they are more concerned about whacking inflation on the head than anything else, which isn't surprising, but does mean that downside growth risks will persist," said Kit Juckes, macro strategist at Societe Generale.

The Fed's federal funds target range is currently 1.5% to 1.75%, after the central bank carried out the first 75 basis-point hike since 1994 earlier in June.

In a Deutsche Bank survey of investors published Thursday, some 90% of respondents said they now expect a US recession before 2023 is done, up from just 35% six months ago.

"That echoes our own economists' view that we're going to get a recession in the second half of 2023, and just shows how sentiment has shifted since the start of the year as central banks have begun hiking rates," Deutsche Bank strategist Jim Reid said.

One plus is that a recession is highly likely to cool red-hot inflation, which is running at a 41-year high of 8.6% in the US.

Bond market investors now expect inflation to average 2.6% over the next five years, according to a measure known as the breakeven rate. That's down from 2.8% a week ago, and 3.6% in March.

Not all analysts and traders expect a US recession, however. Many point to Americans' large build-up in savings during the pandemic, and say it should cushion the blow during any slowdown.

"Suggestions that a recession is imminent or inevitable are well wide of the mark," said Michael Pearce, senior US economist at Capital Economics.

He said surveys of companies show the economy is still strong and that new business continues to flow. "Any recession, if it did occur in the next few years, would be mild," he said.

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