Strategists from the world’s biggest asset manager are challenging traders betting that the Federal Reserve will raise rates to around 3 per cent next year, saying that policy makers will raise borrowing costs to 2 per cent, but not go much further.

An overly aggressive path of hikes to combat the spiraling cost of living may backfire, according to the BlackRock Investment Institute, which estimates that bringing inflation down last year to the Fed’s target of 2 per cent could have pushed unemployment to nearly 10 per cent, based on the historical relationship between inflation and employment.

That’s unlikely to be a scenario that the Fed wants, and means it will eventually “choose to live with inflation,” said Alex Brazier, the deputy head of the institute, noting that inflation is currently being driven more by supply constraints than demand.

Data this week showed that U.S. consumer prices rose by 8.5 per cent in March, the most since 1981. That gauge has historically run about 40 basis points above the Fed’s preferred inflation measure which its policy target is based on.

BlackRock’s view that the Fed will live with inflation underlines its underweight position on bonds. The strategists see the so-called neutral rate -- a level that neither stimulates nor curbs the economy -- at around 2 per cent-2.5 per cent, partly due to the assumption that price growth will soon peak and gradually ease.

The asset manager expects inflation to settle at around 3 per cent, which is still higher than the Fed’s target and its 10-year average. It didn’t provide a specific time frame for the forecast.

While Fed officials mull where their long-term neutral policy rate might be, money markets were recently pricing rates rising to as high as 3.2 per cent next year, and Goldman Sachs Group Inc. Chief Economist Jan Hatzius said last week that the Fed may need to bump rates to over 4 per cent.

“The market is now pricing in a scenario where central banks won’t just normalize rates -- it assumes they will go further and hit the monetary brake,” Brazier said. “That is far from certain because the nature of this inflation is that it’s supply driven.”

Brazier said the Fed’s latest projections confirmed a view that they are not prepared to destroy demand or jobs in order to bring down inflation. While the central bank revised up its inflation forecasts, it kept the unemployment rate steady at around 3.5 per cent, and growth above trend.

Fears of aggressive tightening by the Fed -- which last month kicked off what’s expected to be a series of interest rate hikes -- have triggered a sell-off in bonds, especially at the front end, causing the yield curve to briefly invert earlier this month. An inversion is often seen as a warning sign as it suggests the market assumes the Fed will raise rates so much that it kills inflation, and economic growth, down the road.

The latest price moves in bonds have helped to steepen the curve a bit, with the yield spread between 2- and 10-year notes rising to 33 basis points from minus 8 basis points at the start of the month. The gap, known as term premium, may have further to go as the market adjusts to the Fed’s policy trade off, said Brazier.

“Choosing to fight inflation would raise the risk of a recession, while living with inflation would mean more persistent inflation. The market is pricing some probability of the Fed fighting inflation rather than living with inflation,” Brazier said.