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Fed Monetary Policy Theory


Conditions that are essential for policy decisions… We monitor the increase in employment and inflation after stages such as economic growth, strong fiscal and monetary policy support. Inflation has reached almost 40-year highs, and after the rates experienced during the Volcker era and the bitter policy tightening that brought about a crash, expectations management that needs to be addressed requires further adjustments in monetary policy theory. In this process, we will observe multiple scenario transitions in terms of the Fed’s handling of changing conditions. The Fed has started to reduce its asset purchases and may accelerate the contraction at the meeting where it will announce its decisions tomorrow. Also, markets are pricing in multiple federal funds rate hikes in 2022.


Fed dots chart, June-September change… Source: Bloomberg


Reflections of changing conditions on the nuance of the resolution text… After Powell changed the “temporary” rhetoric for inflation, it is necessary to focus on how the way the issue is handled will be reflected. Therefore, the expectation about inflation will be very relevant to the expectation for how long the spread will last. In other words, we will look at whether it will evolve from an inflation that is expected to be temporary to inflation that is expected to be temporary after a certain period of time, or whether it is based on the fear of a permanent, structural effect. Here we will look at the difference between the expenditure, cost, cyclicality and financial conditions weighting in the economy and the commodity price weighting. If the only problem is seen as commodity prices, inflation will fall back once supply conditions ease a bit. However, the event Nazilli escort may also involve layers very different from out-of-control supply conditions, so the details that will be reflected in the policy statement may be different.


The situation of inflation targeting in the general trend of the CPI… The Fed’s November meeting was guided by the following: “The committee aims to achieve maximum employment and 2% inflation in the long run. With inflation consistently below this long-term target, the Committee will target inflation moderately above 2% for a period of time so that inflation averages 2% over time and long-term inflation expectations remain steady at 2%. The Committee expects monetary policy to adopt a harmonious stance until these results are achieved.“


In the factors that we will consider now, it is very clear that inflation is not moderately above 2% and probably not next year. Thus, in the current environment, there is a difficult QE basis to control inflation rather than mathematically achieving the moderate average inflation target. It also appears that a more rapid reduction in QE by a symbolic amount will not limit this trend, so a new direction for recalibration of financial conditions needs to be established. That is, the Fed will significantly change its inflation guidance to reflect evolving conditions in its statement. It is useful to underline again here; Analysis of the source of inflation is as important as how long inflation will remain high. It is necessary to focus on the qualitative as well as the quantitative aspect. It will be necessary to see if the inflation-warming effect of QE finds its place in the policy text, or how its language is adjusted.


Relationship between labor costs, wages and CPI… Source: Bloomberg


Compared to the inflation environment of the 1980s… Within the framework of the perspective put into practice during the Volcker era, the Central Bank increased the interest rates sharply, and while normalizing inflation in this way, a shock drop in growth had to be endured. If supply shortages aren’t the only source of inflation, we might worry that it would bring such a drastic policy turn from the highest inflation since 1982. So how will the evolution in financial strategy reflect? The event here arises from the priority of managing inflationary concerns. The economy may be performing well on the net, but in an inflationary situation that is income corrosive and will otherwise shape consumer and market behavior in the broad term, a growth perspective needs to be set accordingly. If tighter policy is required, it will have to be implemented.


The importance of interest rates at this stage… We understand that the market will actually focus on interest rates rather than the QE transformation. In the previous Macro Perspective, we discussed the Fed policy on the subject of interest. The main subject here is; will be the response of the interest rate curve at different maturities to the rigidity of movement in policy. At the equilibrium interest point, which will fully adapt to factors such as employment, wages, productivity and efficiency, the ratios that the Fed will go are important. In other words, will there be two or more rate hikes in 2022? The height of wage increases and inflation interactions reveals the difficulty of approaching the issue as a soft transition at the moment.


Inflation and productivity indicators… Source: Bloomberg


Possible action plans… Therefore, we will look at the degree to which the Fed’s action plan will focus on employment and inflation variables and change the status quo in the next statement tomorrow and afterwards. Interest rate conversion is as important as tapering speed, or even higher, in terms of financial conditions being suitable for controlling inflation. If wage increases and employment growth can turn into productivity at the same time, we will not be at a point where we will be overly concerned about the continuation of economic growth. Here, however, positioning according to inflation in terms of workforce motivation and productivity is also important. In other words, if incomes are crushed by inflation, we cannot expect productivity to be sustained. For this reason, the possible risks of the labor market may be a little more secondary, because the risks of variant virus are not too worried at this stage to close the economy. In the scenario analysis of the Fed, we see that the Powell administration will deal with interest, inflation and growth issues, which may affect each other in the opposite direction, from multiple perspectives. The fact that there is no direct reference to the rate hike for a while is due to the observance of this balance point, but the market will enter the stage of creating its own balance by revealing the expectation of a rate hike more clearly.


Conclusion? Even if the Fed abandons the rhetoric of temporaryness in inflation, how it will qualitatively address the factors that feed inflation will be the main indicator on the ground of policy tightening. We think that the factor that will also determine the frequency of increasing interest rates will be the sources of inflation. Therefore, in the strategic financial conditions plan, focusing on an inflation phenomenon that will be managed through tightening will come to the fore. This will be the factor that will come to the fore in the cases that will also determine the reaction of the market. After all, we will see a certain relief in inflation if the main trend in producer inflation eases. However, if this relief will not occur in the foreseeable term, it will be necessary to address the issue from other sources. Because inflation also creates inflation and in such an equation, it can be very difficult to avoid inflation. Factors such as productivity levels, growth and commodity prices in China, the highest level of wages since February 2020, the post-pandemic unemployment rate closest to full employment should be considered separately.


While the old and new conditions in the CPI are evolving, the Fed should also increase real interest rates, in other words, plan an action that will increase interest rates more in line with inflation, especially at the stage of keeping this under control through the interest rate channel. It is not clear whether interest rate rhetoric will come to the fore at this stage. However, increasing the 15 billion dollar tapering slice above 30 billion dollars will reveal a certain policy direction.


However, in the dot chart, the fact that a rate hike is expected in 2022 will no longer be an issue, but the fact that how many rate hikes are expected will be important to us. In the base scenario, if the tapering ends in March 2022, then the first rate hike in a period like June 2022, followed by a rate hike, which is reflected in 4Q22, will be more reflected in the market. It is not clear how much the interest rate increase, which may be 2, will be. Of course, this number can be expected to increase if inflation does not cool. The Fed’s willingness and necessity to intervene will determine these.

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