Fed meeting becomes a test of its inflation narrative

The author is the Dean of Queen’s College, Cambridge University and an advisor to Allianz and Gramercy

This week’s Fed’s monetary policy meeting has gone from a nap to a test of the agency’s control of what it is trying to promote in the market: the current surge in inflation is temporary.

How the Fed responds not only has an impact on the credibility of its policies, but also on President Joe Biden’s economic reforms and global financial stability.

Developments on the ground have forced the Fed into its own position, because a stronger economy challenges the central bank’s commitment not to tighten policy until actual evidence rather than forecasts shows that employment and inflation are at target levels—it’s called Results-based policy framework.

Although long-term uncertainty still exists, the prospects for the recovery of the US economy are now clearer.

Demand has risen sharply, public and private consumption has increased significantly, while corporate investment and manufacturing exports have rebounded. The supplier is responding, but it is not enough.

This has led to a wide range of supply bottlenecks, inventory issues and transportation challenges. At the same time, because there are too few workers who can and are willing to fill the current record vacancies, the large demand for new employees is being frustrated.

Some of these trends are temporary and should be reversed soon. Others are not, and it is likely that significant wage and price increases will continue.

Last week’s US data again included higher-than-expected inflation, with the overall indicator increasing by 5% and the core indicator increasing by 3.8%. They confirmed an upward trend in inflation that was much faster than many expected.

However, despite growing concerns about the scale and scope of this inflationary pressure, the yield on US government bonds has fallen sharply.

This price movement has prompted some people to suggest that the Fed should be relieved that the market agrees with the central bank’s statement that the current price increase is temporary. Although this view may have some advantages, it is unwise to place too much emphasis on it.

The resounding message of the past few years is that unconventional central bank policies can significantly and lastingly suppress yields and distort market signals. They do this in two ways.

First, the central bank’s adequate and predictable securities purchases reassure many people that downward pressure on yields will continue, especially when the central bank indicates that they are willing to engage in non-commercial buyers (that is, not sensitive to high valuations). Second, the lower bound policy rate encourages investors to choose long-term bonds to seek additional income.

When the central bank continues to support its actions by regularly reiterating ultra-loose forward-looking policy guidance, these two effects will be magnified.

For the Fed, this involves three factors: reiterating that it “does not consider” reducing the scale of asset purchases; an unusually long forward committed to To zero interest rate; and shift to Results-based currency framework.

Regardless of the economic reality, these three will help expand market expectations for ultra-loose financial conditions.

This disjointed liquidity paradigm is good news for stock investors, as well as holders and issuers of corporate and emerging market bonds. In the process, it encourages continued migration to more risky opportunities.

But it also comes with considerable risks. In fact, the Fed’s judgment-more like a belief-the spike in US inflation is indeed temporary, and there are more grounds for it. These threats go far beyond the credibility of institutions that are critical to the effectiveness of Fed policy.

It runs the risk of suddenly slamming on the brakes of monetary policy, thereby increasing the possibility of economic recession. Disturbing financial volatility is more likely in the future, which is another potential headwind in the much-needed period of rapid and sustainable growth.

This will lead to an unbalanced policy mix that may undermine the Biden administration’s economic and social reforms aimed at increasing inclusive prosperity and productivity.

It would be wrong to reduce the market’s response to inflation risks to an accommodative attitude towards underlying dynamics. Rather, it reflects a reluctance to respect the ability of the Fed, which is driven by belief, to distort prices for a considerable period of time. However, the subsequent risks should make us all stop to be more humble and open to the nature of inflation.

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