The CNBC Fed Survey shows market expectations have turned aggressive for Federal Reserve policy tightening this year and next, with respondents looking for multiple rate hikes and significant balance sheet reduction.

At the same time, the outlook for the economy has actually improved.

The first hike is now firmly seen coming in March, compared with a June expectation in the December survey. Respondents expect 3.5 rate hikes this year, showing that three are agreed but there is debate over whether there’s a fourth. Half of the 36 respondents see two or three hikes this year, and half see four or five.

An additional three hikes are expected next year. That makes the forecast for a funds rate of just over 1% this year, compared to around zero now, 1.8% in 2023 and a terminal rate, or the end-point of the hiking cycle, at 2.4% reached in March 2024.

“The Fed has pivoted from patient to panicked on inflation in record time,” Diane Swonk, chief economist at Grant Thornton, wrote in response to the survey. “That ups the risk of a misstep in policy, especially in light of the complexity of inflation dynamics today.”

The central bank’s two-day meeting ends Wednesday, where it is expected to give more clues as to when it will hike rates and begin shrinking the balance sheet. Chairman Jerome Powell will also address the media.

The balance sheet runoff is seen beginning in July, much earlier than the last survey, which pegged the beginning in November. While the Fed has yet to formulate a plan for balance sheet runoff, here is a first look at how respondents believe it could happen: 

• $380 billion to come off the $9 trillion balance sheet this year and $860 billion in 2023.
• Monthly runoff pace of $73 billion eventually, far faster than the last runoff in 2018, but the Fed will phase in this monthly pace.
• $2.8 trillion in total runoff or about a third of the balance sheet over 3 years.

Most support the Fed reducing the mortgage portfolio before Treasurys, letting short-term Treasurys runoff before long-term ones and only reducing the balance sheet by not replacing securities that mature, rather than outright asset sales.

“Investors are under-appreciating risk in the financial system,” said Chad Morganlander, portfolio manager at Stifel Nicolaus. “The wave of liquidity and the zero-interest policy have distorted all markets. The Federal Reserve should have shifted policy a year ago.”

91% of respondents say the Fed is significantly or somewhat late in addressing inflation.

“The Fed should start by raising rates aggressively, that is, 50 bps initially, so it can throttle back later when/if supply chain issues start resolving themselves and inflation comes down as a result,” wrote Joel L. Naroff, president, Naroff Economics LLC, in response to the survey.

Respondents marked down their outlook for stocks but only modestly compared to how much they boosted their outlook for Fed rate hikes. The S&P 500 is seen ending the year at 4,658, or a 5.6% increase from the Monday close. That’s down from the December forecast of 4752. The S&P is forecast to rise to 4889 in 2023.

The CNBC Risk-Reward ratio, which gauges the probability of a 10% increase or decline in stocks over the next six months, fell to -14 from -11 in the last survey. There is an average 52% probability of a 10% decline in the next six months, compared to just a 38% probability of a 10% gain.

While the outlook for Fed tightening has increased, respondents’ economic outlook actually improved. The forecast for GDP rose to 4.46% this year, up by half a point, and to 3.5% for 2023, up about the same amount. Higher real or inflation-adjusted growth comes amid expectations for higher inflation, with the outlook for the CPI raised by about 0.4 percentage points this year to 4.4% and to 3.2% next year.

The unemployment rate is expected to fall to 3.6% this year, compared to the current rate of 3.9%. The chance of recession in the next year rose to 23% from 19% but remains about average. Inflation is seen as the No 1. threat to the expansion and 51% believe the Fed will have to raise rates above neutral to slow the economy.

“Assuming the pandemic continues to recede – each new wave of the virus is less disruptive than the previous one – the economy will be at full employment and inflation near the Fed’s target by this time next year,” wrote Mark Zandi, chief economist, Moody’s Analytics.