The Fed will raise rates to 5% to get a grip on inflation, Deutsche Bank says

• The Fed may have to raise its policy rate to 5% to get a grip on inflation, according to Deutsche Bank.
• The bank's economists said the Fed typically overshoots the inflation rate before starting to cut.

The Federal Reserve will have to raise its policy rate to 5% in order to get a grip on high inflation, according to Deutsche Bank.

That defies any hope for a policy pivot in the near future. Shortly after August inflation clocked in above estimates at 8.3%, markets priced in expectations of another 75-point rate hike from the US central bank next week, causing stocks to notch their largest one-day decline since 2020.

"Despite the recent jump in market pricing for the fed funds rate, [our] analysis therefore points to further upside risk to terminal rate expectations," a team of Deutsche economists warned in a note on Thursday, noting that continued "surprises" in inflation reports could lead to a terminal rate above 5%.

That's largely because inflation still remains "well above" the Fed's target of 2%, and while other experts have pointed out that prices are falling across the board, job reports show that the labor market is still booming, which Fed officials have interpreted as a sign the economy can withstand further tightening.

Powell previously stated that the Fed would keep tightening "until the job is done," suggesting the Fed will pursue the neutral policy rate – a rate level is no longer restrictive to the economy – before thinking about cuts.

But the neutral policy rate is often reached by shooting past the inflation rate, the bank said. A Deutsche analysis of previous inflation cycles showed that the terminal policy rate almost always exceeds the inflation rate in order to "ensure sufficient tightening" in the economy, regardless if inflation was severe or mild.

The economists estimated that the Fed would need .25% real neutral fed funds rate or overshoot to fully catch up with inflation, likely disappointing investors banking on a rate cut.

"In particular, with core PCE inflation now likely staying north of 4.5% through year end and into early 2023, the terminal fed funds rate would need to exceed these levels … After accounting for a slightly positive real neutral rate, a terminal rate above 4.5% is likely to be necessary," the bank said.

But inflation continues to bust estimates and the labor market remains tight. That could raise the terminal rate above 5%, which would be over double the Fed's range of 2.25%-2.5%.

"At this point, we see the risks skewed in the hawkish direction," the bank warned. Other analysts have speculated the US could tip into a recession from prolonged Fed hawkishness, and billionaire investor Ray Dalio this week predicted that hiking rates to 4.5% could lead to a 20% drop in the stock market.