With the US Federal Reserve set to meet Tuesday and Wednesday, and interest rates expected to rise as a result, what will the rate hike path look like in 2018? To Bank of America Merrill Lynch’s Global Economist Ethan Harris, understanding the Fed and their future actions requires taking a long view that goes beyond one rate hike. Going back to 2016 he notes an increasingly hawkish central bank not just by the words they use, but by their actions. With the markets basically nonplused to rate hikes of late, he expects central bankers to be emboldened in 2018 and is keeping his eye on the yield curve to benchmark the action.

After strong jobs report, rate hike likely -- and watch for a lack of market reaction as Fed "reloads"

Last week’s November jobs report, revealing 228,000 new jobs were created, might have solidified the Fed’s plan to hike interest rates at meetings this week. If they do announce at Janet Yellen's last meeting to notch up short term interest rates, it will be the third time in 2017 and the fifth time since December 2015. They will not only be attempting to put a damper on an economy before it significantly overheats, but they will be “reloading” their own toolkit at the same time.

Harris notes that the objective in rate hikes is not only to subtly cool the economy. “Imposing pain in the markets is not only necessary for achieving near-term growth and inflation objectives, it is also essential if the Fed hopes to “reload” its policy weapons,” he wrote in a December 11 report titled “If at first you don’t succeed…”

Saying that “there is no such thing as a painless Fed hiking cycle,” he notes that the central bank is doing more than just “creating a modest restraint on growth.” They are preparing themselves in case they need to fire economic bullets to boost the economy in the near future should markets experience difficulty.

“How much lower can the Fed push term premiums in the next crisis? Obviously, other central banks such as the BOJ and ECB are even lower on ammunition,” he noted, pointing to a delicate tightrope that could be a self-reinforcing cycle.

Of course, central banks face a huge constraint in this effort: they do not want to tighten too fast and shock the economy or stop the recovery in inflation. In other words, there is a thin line between their reloading versus shooting themselves in the foot. If the markets react strongly to the Fed, it will be forced to slow or stop the “reloading” process.

For Fed watchers, understanding where in the game the Fed stands might involve recognizing key benchmarks.

The boiling frog strategy relies on a slow turning up of the rate hike heat

The Fed has become increasingly hawkish since they started hiking interest rates, but they have been delicate about their communication so that their actions don’t jolt markets.

In the fall of 2016, the bond market was pricing in just 1.5 rate hikes through the end of 2017, but they got five. Citing the Fed’s survey, back in July 2016 primary dealers were not expecting the Fed to announce balance sheet shrinkage until July 2018. This announcement came in September 2017 – and it was more aggressive than anticipated. In July 2016 primary dealers were looking for the Fed balance sheet to shrink to $3.9 trillion by the end of 2019. Now, however, the plan is more aggressive, shrinking the balance sheet to $3.6 trillion.

The more aggressive Fed is encouraged by the market’s lack of reaction. Unlike the “taper tantrum” when it first announced interest rate hikes in 2015, its successive moves have been more a boiling frog approach, with the market not noticing the slow turning up of heat.

When will the rate hikes end?

Harris advises clients to watch the yield curve for clues. He watches the yield curve height among three primary benchmarks:

First, In today’s world of unconventional policy central banks manage both ends of the curve—tight policy is measure by the height of the curve not the height of the short end relative to the long end. Second, and related, with negative term premiums it is easy to invert the curve. Third, with strong growth, and strength across asset markets, the Fed is likely to view low bond yields as just another sign of easy financial conditions. Why would they assume the bond market is right about weak growth and every other market is wrong?

Harris thinks core inflation will start to rise in 2018 – a view that comports with Goldman Sachs recent comments that commodities could be the best long investment throughout the year. The big question becomes: if inflation becomes overt, and rate hikes become aggressive, what does that do to stocks?