The author is Co-Chief Investment Officer at Bridgewater Associates

As economies continue to transition from adrenaline-pumping takeoffs to more self-sustaining growth, policymakers will increasingly face the most challenging choices since the 1970s.

Monetary and fiscal stimulus implemented in the U.S. and most advanced economies during and earlier during the pandemic lifted incomes, filled the gap between rich and poor and boosted household wealth.

Importantly, the resulting spending is measured in nominal value before inflation is taken into account. This has to do with nominal credit flows initially from government credit expansion, financed by printing money. How nominal spending is divided between real GDP and inflation depends on the amount of production.

So far, production has not been able to meet such high levels of nominal demand or expand fast enough. As a result, extremely high levels of nominal spending are generating a lot of inflation, which is seeping into the cost of living and wages and the need to keep up.

In other words, a self-reinforcing inflation cycle is taking shape. We now face the greatest potential for a sustained rise in inflation in decades.

These situations will require a policy transition. It’s clear that policymakers are now aware of this, but it’s unclear how aggressive their moves will be. Given this situation, they may be moving too little and too slowly.

The pandemic and near-zero interest rates make their choice especially difficult. With Covid-19 and the constant risk of new variants emerging, there will continue to be questions about whether rising inflationary pressures will persist, as well as continued uncertainty about the impact of the pandemic on economic growth.

These issues will be compounded by the asymmetric ability of central banks to tighten and loosen. Policymakers have a whole set of policies to tighten. But with nominal interest rates near long-term lows and asset prices high, they have only one form of stimulus — money printing coordinated with fiscal expansion.

Now that leverage is less available, as rising inflation is creating political resistance to further action. With the politics of government spending now a growing concern, if the Fed tightens too much, it could even enter a period of fiscal drag rather than stimulus.

Finally, the Fed will be concerned about the economy’s sensitivity to rate hikes after it was forced to quickly reverse its policy tightening in 2018. Taken together, this set of circumstances has prompted the Fed to keep monetary policy looser for longer, leaving room for a more ingrained inflation cycle.

While the Fed and other central banks may be concerned about heightened sensitivity to tightening, the economy may actually be less sensitive to rising interest rates than recent experience suggests.

Improvements in household balance sheets, especially those of the middle class, imply a greater degree of resilience to monetary tightening. Given rising inflation, there is more room to raise nominal interest rates without tightening real conditions.

Under this set of conditions, the economy’s reduced sensitivity to rising interest rates, combined with a cautious approach to rising interest rates, would further increase the risk of falling behind the curve, followed by more pronounced tightening with greater economic impact and market at the time.

So how much and how fast should they move? Given the current low unemployment rate, in order to achieve target inflation, austerity must slow nominal demand growth to a level just above labor force and productivity growth.

Doing this requires a combination of the reserves banks hold at the Fed and a rise in real interest rates. It also requires higher interest rates relative to market discounts and increases in short-term bond yields relative to longer-term bonds. Of course, the process is a dance related to unfolding conditions, but these will be important criteria.

For investors, these situations create two unique risks compared to the past four years. First, there is a risk of asset values ??falling in real value as inflation continues to rise. Second, there is a risk that the central bank will fall further behind the inflation trend and have to actively catch up.

In the short term, continued accommodative monetary policy tends to have benign effects similar to mid-cycle economic transitions. However, too much delay can mean overstimulation. The long-term risk is that the Fed lags behind in tightening policy and is then forced to catch up with a larger response.