Wall Street next week will shift its focus from earnings to the Fed, with the Federal Open Market Committee (FOMC) issuing its monetary policy statement on Wednesday afternoon, following a two-day meeting.

The consensus market forecast is that the FOMC will raise its key Fed Funds rate —a critical short-term rate — by 50 basis points, with some forecasts calling for a 75-basis-point rise. In addition, the FOMC is expected to state how it plans to reduce its balance sheet, which will set the pace for long-term interest rates like Treasury bonds and mortgage rates.

This time around, the FOMC is meeting amid several old and new challenges. First and foremost is inflation, which has turned from a transitory to a permanent problem.

It's running at a 40-year high, beginning to take its toll on Main Street and Wall Street. For instance, record inflation is one of the drivers behind the strong dollar, which widened the U.S. trade balance in the first quarter of 2022, pushing GDP growth to negative territory.

Meanwhile, a stronger dollar feeds into the inflation spiral through the demand-pull and cost-push processes. As a result, it's hurting companies' earnings with significant exposure to overseas markets.

Second is the Russia-Ukraine war, the critical force behind the food and energy inflation acceleration, which doesn't seem as if it will end soon.

The third is a host of high-profile earnings disappointments, which have fueled vicious Wall Street selloffs, including a couple last week. Wall Street selloffs destroy wealth, putting additional pressure on consumer spending, and could eventually push the U.S. economy into an outright recession.

Once again, the Fed may be facing a hard dilemma. It could be hawkish by raising interest rates quickly to fight inflation and risk a recession or be dovish, raising interest rates slowly to avoid a recession but risking runaway inflation.

What's the most reasonable solution to this dilemma?

"The Federal Open Market Committee will raise the federal funds rate by 0.5 percentage points to a range of 0.75% to 1.00%," Gus Faucher, chief economist at the PNC Financial Group, told International Business Times. "This will raise short-term borrowing costs throughout the economy, weighing on economic growth."

What about the balance sheet?

"The FOMC will also announce that it will start to reduce the size of the Federal Reserve's balance sheet sometime over the next few weeks," Faucher said. "As long-term Treasurys mature (up to $60 billion per month) they will not be replaced on the Fed's balance sheet. Similarly, up to $35 billion of mortgage-backed securities and Fannie Mae/Freddie Mac securities will not be replaced. The Fed is more likely to have the full amount of Treasurys roll off. But there might not be $35 billion of MBS maturing every month; in that case, less than $35 billion would roll off the balance sheet."

How would markets respond to these policy changes?

"Markets have already priced in both of these actions," Faucher said. "That is why interest rates across the economy, particularly long-term interest rates, have been moving higher. For example, the yield on a 10-year Treasury note has increased from 1.63% at the beginning of the year to 2.89% currently. Similarly, the rate on a typical 30-year fixed mortgage rate has risen from 3.22% to 5.10% over the same period."

Still, it's unclear how far the Fed must go to bring inflation under control, which could add to market volatility.

"It's no secret the Fed will raise rates half a percentage point, but what it signals for the rest of the year is unknown," said Robert Frick, corporate economist at Navy Federal Credit Union. "Hawks want tough talk about future rate hikes, pushing the federal funds rate to near 3 percentage points by year-end, but the Fed may want to keep its options open and emphasize future hikes are still 'data-dependent,' as Fed Chair [Jerome] Powell stated as recently as January. We shouldn't be surprised if the Fed hedges now that inflation has apparently peaked."

Depending on earnings, market volatility can become better or worse.

"Markets are likely to remain volatile, but based on what we're seeing in first-quarter reporting and will see in second-quarter reporting, and as the year goes on, better, more durable companies are able to deliver more consistent and strong results," Matt Benkendorf, chief investment officer at Vontobel Quality Growth, told IBT. "At the same time, finally, some of the more expensive stocks in the market can and should come down in price. Some of the so-called 'darlings' have been having problems or are starting to quickly hit a wall. I think we will start to see a more realistic scenario, identifying the more quality businesses."

While the Fed is still in the early stages of monetary tightening, the higher interest rates could help cool off inflation.

"With a more aggressive push for rate increases, it's very likely, at the same time, to see inflation starting to decline, even absent any change of prices in the real world, simply due to year-over-year comparisons over the next few months,” said Benkendorf. “Following the Fed's expected step up in interest rates next week and likely another one after that, we have the potential for a shift in sentiment."