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Cross Risks and Practices Implied in Fed Monetary Policy

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The current situation on the Fed’s policy ground… Increasing inflation expectations in the US continue to gain weight together with current data and the situation. The basis of the incentive policies that revitalize the economy that came with Covid, which is no longer useful for the purpose, has emerged with supply problems that actually create inflation. In particular, the reflection of the problems in the supply of raw materials to production and the warming effect of demand, the necessity of controlling the primary effects has emerged. Because pricing behaviors are changing and inflation is approaching the stage of creating a corrosive effect on incomes. The Fed wants to control an inflation base that is stable and compatible with projections, so that it will be easier to maintain the anchor they have set for the temporaryness of inflation. Reducing asset purchases and accelerating contraction when necessary is seen as the way to achieve this control.

 

The Fed’s implied policy rate and the number of rate hikes/cuts priced in… Source: Bloomberg

 

How does CPI affect rate expectations? Under normal circumstances, the proportional base effect of the high inflationary period, the expectation of normalization of supply chains, or the rapid disinflationary effect of tightening policies this time cause the Fed to stay in the middle of monitoring the situation. In other words, the rate hike is not something they want to address right away. However, the problem in inflation comes from the following; The price increase in many products has passed the effect of the items related to the pandemic and they have become the main driver of inflation. Cost factors related to input and energy supply are at a point where they will affect inflation through the general spillover effect. While the employment gap is gradually closing in the economy and it is still not at the point of full employment, the demand factor is also warming. Therefore, in the full employment position, the permanent income effect may affect the inflation as it means spending confidence. For this reason, expectations regarding the timing of the rate hike and its frequency are coming to us within the framework of high CPI realizations. The peaks recorded in 5-year and 10-year break-even inflation rates and the increase in the frequency of movements in short-term inflation expectations indicate that the market is more concerned about this issue.

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United States break-even inflation rates… Calculated by subtracting the real yield of the inflation-related maturity curve from the yield of the nearest nominal Treasury maturity. The result is the implied inflation rate for the specified maturity period. Source: Bloomberg

 

What will the Fed do if it’s more worried about high inflation? Reducing asset purchases was initiated in monthly tranches of $15 billion. If we go at this speed, June 2022 will coincide with the end of QE. So when is the rate hike? We are not at a point where we can be completely sure of that. Because it is not clear exactly when the supply chain troubles will end and return to normal. On the other hand; We believe in two important facts: economic progress, which will largely be achieved in a position of maximum employment, and inflation, which may be persistent and whose long-term effects will be difficult to maintain. In fact, the first of these facts is one of the causative agents of inflation, but at this stage it is not the first priority. However, wages that continue to rise are the main component of demand inflation as they also give confidence in spending. When this environment is provided, it is not known what level the economy will be and what level of inflationary concerns will be. However, we will also have the opportunity to see where the signal effect is when the Fed revises expectations at its December meeting.

 

Markets are pricing in a federal funds rate hike by September of next year, compared to the Fed’s latest forecasts pointing to 2023. While this is likely to slip into the June-July 2022 timeline depending on the situation, we do not think that the Fed is considering getting into an aggressiveness at this stage that risks derailing the recovery. Our first option would be to increase the rate of decrease in asset purchases and adjust accordingly if the degree of discomfort with inflation increases.

 

Comparison of US 2-year and 10-year bond yields and CPI… Source: Bloomberg

 

The threshold to respond to inflation with policy aggression… At some point in the future, the Fed will have to decide at what scale to continue the pace of asset purchases. Assuming the economy continues to improve in the Fed’s strategy to cut securities, it is considered to address the increase in the fed funds rate after asset purchases. However, Fed Chairman Powell emphasizes that reducing asset purchases and increasing the interest rate are independent decisions, suggesting that they are matters of progress at different layers. The speed and timing of the contraction is at a point where the rate hike is not directly referenced but indirectly over the market.

 

The larger-than-expected spike in inflation fuels speculation that the Fed will raise interest rates sooner. In October, CPI increased by 6.2% compared to the previous year and recorded its fastest annual increase since 1990. After the data, the reflection in inflation expectations also pushes up the inflation break-even rates. Bond market expectations for the pace of inflation over the next decade rose to a level not seen since 2006 on Friday. Rising inflation increases the sale of nominal-rate bonds, while increasing the reflection on inflation-protected bonds. These reverberant movements indicate greater concern over the risk that inflation may be more persistent than initially assumed. Although the reduction in asset purchases is the theoretical harbinger of the upcoming rate hike; A higher and persistent inflation supports the idea that earlier and higher-frequency rate hikes may occur.

 

Conclusion? Inflation has hit a 30-year high, fueling concerns that rising inflation will likely continue for longer than originally thought. As a result, expectations of increasing the federal funds rate have been pushed forward. Although supply problems are the most important reason for the increase in inflation in recent months, product scarcity caused by excessive demand also contributes to this. Naturally, the price level curve shifts higher. We think that inflation is dragging on two wings at the moment. If we consider that this has happened before the maximum employment point has been achieved in terms of the entire economy; Improvement in conditions may also contribute to demand inflation.

 

In order to avoid destabilizing inflation expectations, the Fed will evaluate overall trends and progress data on economic growth in detail, and may make further front-loaded tightening if necessary. As tighter monetary policy won’t fully support conditions such as Covid, production cuts or a return to the workforce, the Fed prefers to maintain a foothold that does not harm the pace of recovery. There is also concern that an aggressive tightening could lead to a hard landing or higher-than-desirable disinflation. The Fed will continue to reduce its asset purchases at the pace indicated at the current stage, while guidance on future rate hikes will be based on the threshold of being more concerned about inflation.

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