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

The market will be trading with major central banks for most of 2021, especially the Fed’s guarantee that inflation will be temporary and monetary policy will continue to maintain a super stimulus model. This powerful condition promoted the “all rebound” of the market. It will be different in 2022.

The market will no longer have a foreseeable massive injection of liquidity to power them through unknown and turbulent economic waters. Crucially, investors will have to consider the persistence and impact of the inflation spike, including the drivers of its eventual demise.

For more than a decade, the central bank’s large-scale asset purchase program in the market has not only boosted the assets being purchased, but also boosted almost all other assets, whether financial assets or physical assets (such as housing, art, and other collectibles). ). This is especially true in 2021, when the central bank’s cash injection reached a record monthly level.

After continuing to eliminate the threat of inflation, the Fed’s focus on this issue is that it’s better to be late than not to be part of the global central bank’s general shift to reducing monetary policy stimulus. Although its policy stance will remain accommodative for a considerable period of time, the world’s most powerful central bank is now preparing to completely stop asset purchases at the end of the first quarter.

More and more other central banks (not only in the emerging world, but also in some advanced economies such as Norway and the United Kingdom) have begun their interest rate hike cycle. All of this is happening at a time when fiscal policies in many countries are about to become less stimulating, even though the new coronavirus variant Omicron is suppressing economic growth.

The Fed started late and faced challenges in reducing stimulus when fiscal policies were not so stimulating; market-based financial conditions were more unstable; strong household income and expenditures are gradually being eroded by inflation and steady consumer spending; Omicron is now Inflationary pressures are exacerbated by new disruptions in the supply chain and the availability of workers.

Once asset purchases are over, these challenges will not prevent the Fed from raising interest rates. But they do raise important questions about the durability of the hiking cycle.

The market is already opposing the view that actual policy will verify the interest rate path predicted by Fed officials at the December policy meeting. What is not clear is whether this is a question of will or ability.

The Fed may lose its courage, as it has repeatedly done in recent years, the market will see it as constructive in the short term. This will allow the central bank to participate in offsetting asset price shocks, which is especially beneficial for stocks that benefit from the “least dirty shirt phenomenon” (ie, not all attractive but superior to most other asset classes).

If this happens at the same time as the orderly reduction of inflationary pressures (still a consensus view), it will be more supportive. This is still possible-only-if the Fed immediately takes more steps to keep up with developments on the ground.

The situation of “incapability” is even more problematic. Here, a system conditioned on the lowest interest rate for more than a decade and sufficient liquidity will soon prove that higher interest rates cannot be tolerated.

The tightening of financial conditions, although guaranteed by continued inflation, will lead to a highly unfriendly combination of financial instability and declining private demand. In the extreme case-stagflation-when the market is dealing with the three previously underestimated liquidity, credit, and solvency risks, policies become less effective.

In this “powerless situation”, inflation will eventually fall, but the process may lead to a sudden and sharp drop in economic activity.

As the new year approaches, both the Fed and the market have a huge stake in the orderly decline of inflation. But the window of policy opportunity to achieve this goal is rapidly closing. Another option is a disorderly decline, which will involve a greater Fed policy error, that is, having to tighten monetary policy too abruptly after the previous tightening of monetary policy was too slow.

In addition to direct damage to the economy, this may lead to financial market accidents, thereby magnifying another round of unnecessary and greater damage to livelihoods.