A 4% fed funds rate is on traders’ radar for 2022. But it could take up to two years for hikes to make a big inflation impact.

Financial markets in the U.S. remain hyper-focused on the prospect of a continued climb in interest rates, with traders putting a better-than-50% chance on the Federal Reserve’s main policy rate target getting to a 15-year high of between 3.75% and 4% by December.

But now a branch of the U.S. central bank is flicking at the likelihood that rate hikes may not have any apparent major impact on inflation for about 1.5 to 2 years, as economists like the famed Milton Friedman have demonstrated time and time again.

In a blog on Wednesday — called “Lessons from the Past: Can the 1970s Help Inform the Future Path of Monetary Policy?” — Atlanta Fed economists Federico Mandelman and Brent Meyer offer insights for traders and investors seeking to readjust to a more hawkish U.S. central bank.

As traders began putting a 4% fed funds rate for 2022 on the radar, broader financial markets moved with a lack of conviction on Wednesday, the final day of August trading: U.S. stocks DJIA, -0.88% SPX, -0.78% COMP, -0.56% ultimately finished the day with their fourth straight session of losses, while the policy-sensitive 2-year Treasury yield TMUBMUSD02Y, 3.507% was slightly lower at 3.45% as investors await Friday’s release of fresh nonfarm payrolls data.

Read: U.S. likely added 318,000 jobs this month — but beware an August surprise

“People tend to keep their money closer to the vest in these periods of uncertainty, and it’s almost anyone’s guess what’s taking place” when it comes to inflation, the direction of the economy, and how high interest rates will go, said head trader John Farawell with Roosevelt & Cross, a bond underwriter in New York. “Historically, September is not  such a great month for equity markets” and there could be weakness in both equities and bonds next month.

A 4% fed funds rate by year-end “would hurt asset markets for a while until inflation comes down and gets back to normal,” Farawell said via phone on Wednesday.

Trouble is that no one knows for sure how long it will be before inflation returns to the Fed’s 2% target. The Atlanta Fed’s blog adds to doubts that rate hikes will be able to ease persistent price gains soon. The idea of a monetary-policy lag is well known in economic circles, but has been less a part of the broader public narrative on inflation.

In particular, Mandelman and Meyer cited a 1971 speech that Nobel Prize winner Friedman delivered to the American Economic Association, which gave rise to the phrase “long and variable lags” to describe the delayed effect the Fed’s rate moves have on the economy. The main thesis of Friedman’s remarks a half-century ago “still rings true,” they said. “Changes in the stance of monetary policy have the largest impact on output first and then, much later, on inflation.” 

“That context is especially useful for monetary policy makers to keep in mind as they navigate the economic challenges of the pandemic,” the Atlanta Fed economists wrote. They also note that, in the 1970s, it was changes in the money supply that were the Fed’s primary instrument and the fed funds rate “played only a secondary role.”

Shirts with the images of Milton Friedman and Austrian-British economist Friedrich Hayek were for sale at a political conference in Maryland during 2018. CHIP SOMODEVILLA/GETTY IMAGES

Over much of the past year, many economists and investors have regularly dismissed the notion that a 1970s-style stagflation environment was developing in the U.S., even as inflation readings shot higher or remained elevated, and the economy showed signs of slowing. But it’s not only the U.S. that’s got problems: Inflation in the eurozone also hit a record 9.1% year-over-year gain in August, and Europe’s energy crisis is deepening, adding to further worries.

Financial markets have a tendency to look for quick results and cheered July’s decline in the U.S.’s annual headline consumer price inflation rate to 8.5%, from 9.1% the prior month, only to have Fed Chairman Jerome Powell reaffirm the central bank’s commitment to tackling inflation despite the pain to households and businesses. In his widely followed Jackson Hole speech last Friday, Powell also cited lessons from the 1970’s.

Wednesday’s research from the Atlanta Fed, which produces the GDPNow forecasting model and is led by President Raphael Bostic, reinforces the likelihood of no quick fixes; theoretically, that would tend to support continued financial-market volatility. They cited the Fed’s tendency in the 1970s to tighten policy and quickly reverse course as a recurring theme that “never allowed inflation to fall back to the 1 to 3 percent range that was the norm after the end of the Korean War.”

“As a consequence, the expectation that inflation would not recede into the background eventually became embedded into the psyche of Americans,” the Atlanta Fed economists wrote. “People who lived through this experience simply anticipated higher future inflation rates, with that expectation embedded into their price-setting and wage-bargaining decisions.”

In the days that followed Powell’s Jackson Hole speech on Friday, Steve Hanke, a professor of applied economics at Johns Hopkins University, told CNBC he thinks inflation is going to stay high because of “unprecedented growth” in the money supply and the U.S. is heading for a “whopper” of a recession next year, though not necessarily because of higher interest rates. And on Wednesday, Cleveland Fed President Loretta Mester added her support to raising the fed funds rate above 4%, from a current level of 2.25% to 2.5%, and said she does not expect rate cuts next year.

What happens to financial markets and the U.S. economy if or when the fed funds rate target gets to 4%  “will depend on where inflation is” at the time, said Michael Landsberg, chief investment officer of Punta Gorda, Florida-based Landsberg Bennett Private Wealth Management, which manages $1 billion in assets.

“If inflation is 7% and the fed funds rate is 4%, that won’t be good for markets since more rate hikes will be coming,” he wrote in an email to MarketWatch. “If inflation is coming down towards the fed funds rate, I don’t think it would be that bad.  I think we will see a recession and I don’t think that is built into the market at this time.”

“There is still a lot of misplaced optimism that the Fed will start lowering rates next year because inflation will be under control,” Landsberg said. But “inflation in the U.S. will be stickier than many believe and it is downright nasty ( and still going up) in Europe.”