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Traders work on the floor of the New York Stock Exchange in New York City on June 14.Spencer Platt/Getty Images

Investors are betting the U.S. Federal Reserve will announce its first 75 basis point interest rate hike since 1994 on Wednesday – a sharp shift in market expectations in recent days as inflation proves more stubborn than expected.

The U.S. central bank, like the Bank of Canada, is pushing rates higher rapidly in an effort to tackle inflation.

Following a 50 basis point rate hike in May, Fed officials signalled another half-point move was likely at their next meeting on June 15. In recent days, however, financial markets began to disregard these signals and priced in a larger move.

Market expectations for a 75 basis point rate hike rose above 90 per cent on Tuesday, up from just 4 per cent a week ago, according to the CME Group’s FedWatch tool. It is based on futures contracts used to hedge exposure to interest rate moves.

This shift in investor sentiment has roiled financial markets. Bonds, equities and alternative assets such as cryptocurrencies have sold off dramatically in recent days.

The yield on 10-year U.S. government bonds has risen more than 40 basis points since Friday – hitting 3.49 per cent on Tuesday, the highest level since 2011. (Bond yields and prices move in opposite directions.)

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Meanwhile, the S&P 500 index officially entered a bear market after falling nearly 4 per cent on Monday. Stock markets stabilized on Tuesday, with the S&P 500 falling 0.38 per cent, while the Nasdaq Composite rose 0.18 per cent.

A sharp jump in the Fed’s benchmark federal funds rate this week could increase the likelihood of a “hard landing” – a scenario in which the central bank pushes the U.S. economy into recession to tackle inflation and prevent expectations of further price increases from becoming unanchored.

The change in market rate hike expectations followed publication of U.S. Consumer Price Index data on Friday. It showed the annual rate of inflation hit 8.6 per cent in May, the fastest pace of price growth since 1981. That exceeded Wall Street estimates and frustrated hopes that inflation was starting to plateau.

A pair of reports published in recent days by the Federal Reserve Bank of New York and the University of Michigan added to the argument for a supersized rate hike. They showed Americans are increasingly expecting inflation to remain high. This is a dangerous situation for the Fed, as inflation expectations can be self-fulfilling, with companies setting prices and employees demanding wages based on where they think inflation is headed.

“We can’t allow a wage price spiral to happen, and we can’t allow inflation expectations to become unanchored,” Fed chair Jerome Powell said in a news conference after the central bank’s meeting in May. “It’s just something that we can’t allow to happen.”

Markets also appear to have reacted to a story published in The Wall Street Journal on Monday, which said recent CPI and inflation expectations data “is likely to lead Federal Reserve officials to consider surprising markets with a larger-than-expected 0.75-percentage-point interest-rate increase.”

The Fed is in a blackout period ahead of the rate announcement, and has not commented on recent market moves. Mr. Powell said in May a 75 basis point increase “is not something the committee is actively considering.”

“Hiking 75 is not going to be a costless move by the Fed,” Derek Holt, head of capital market economics at Bank of Nova Scotia, wrote in a note to clients.

“If they do indeed hike by 75bps tomorrow, then even their one-meeting ahead forward guidance will become utterly useless. Every meeting will become open season on the Fed and power to drive market volatility will be handed over to media outlets.”

Fed officials have emphasized the need to be “nimble” and adjust monetary policy based on incoming economic data.

The federal funds rate is currently set at the 0.75 per cent to 1 per cent range. Markets are expecting the Fed to push this rate sharply higher in the coming quarters, reaching close to 4 per cent by early next year.

In Canada, central bank officials have said in recent weeks that they are open to a 75 basis point interest rate increase. The Bank of Canada raised its policy interest rate by 50 basis points at the beginning of June, and said it was “prepared to act more forcefully if needed.”

Bank of Canada Governor Tiff Macklem said last week there is a growing likelihood the bank will need to push its benchmark rate to 3 per cent or above to deal with surging inflation

“We may need to take more interest rate steps to get inflation back to target. Or we may need to move more quickly, we may need to take a larger step,” he said.

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