The US March inflation, which stands out as the most important economic data event of the week, will be essential in terms of showing that both external price pressures and the effect of income erosion are growing. The estimated annual inflation rate for March is 8.4%, meaning that inflation will move up from 7.9% in February, setting a new peak after December 1981. Core inflation is also expected to rise to 6.6% (the highest since August 1982). The Russia-Ukraine crisis, rising commodity prices and disruption in supply chains supported the upside risks in inflation. Oil and other commodity prices, which were also high before the Ukraine war, tested highs in early March. Leading indicators that business costs rose at a rate not seen since 2008 in March raise concerns that the worst of inflation has yet to be tested. These high costs are increasingly passed on to customers, leading to record inflation rates in the US.
Of course, the guidance of the data will be important in terms of the belief that the Fed will fight high inflation with increasing determination. Production costs continue to rise with increasing pressure due to problems in supply chains. A significant part of the increase will be due to gas prices, but strong increases can also come to the fore in the food, housing and services sectors. The 20% increase in pump prices in March will probably add about 1 point to inflation alone, which alone can increase the deviation range from the market expectation. Sales prices of US firms continued to rise last month, with consensus expectations similarly pointing to faster inflation amid the Ukraine war and economic crisis. The Ukrainian occupation is also expected to put additional upward pressure on agricultural commodity prices. Further increase in food cost inflation creates the main impact on the purchasing power of the wage-earned segment of the society, because such an increase in non-discretionary expenditures not only reduces aggregate demand, but also causes a decrease in autonomous consumption ability, creating a general pressure effect on the economy.
Inflation subcategories and contribution degrees… Source: Bloomberg, Bureau of Labor Statistics
Marking the Fed's growing determination to tackle hyperinflation, the March FOMC meeting minutes left the door open for further hawking. CPI data for March will confirm the views of the market for a 50 basis point rate hike in May. The expectation of the Fed to act proactively in the following meetings is also increasing. The uncertainty of the Russia-Ukraine war prevented the Fed from taking a 50 basis point step in March. Members of the Fed, especially Powell, give the green light to more aggressive interest rate hikes and rapid balance sheet reductions, causing expectations to rise. The movement of term funds keeps the 50 basis point expectation on the radar in May and June, while the possibility of a double-effect rate hike in July increases. The US 10-year bond yields have been pushed above the 2.80% band as a result of the pricing of the aforementioned inflation and tightening phenomena.
The Fed plans to increase the effect of interest rate hikes with balance sheet reductions. The planning of this was revealed in the Fed minutes. Accordingly, a balance sheet reduction operation will start with a scale of 95 billion dollars a month, 60 billion dollars of this shrinkage will be made from Treasury debt instruments and 35 billion dollars from MBSs. The Fed will reevaluate the plan every three months. Considering the balance sheet is around $9 trillion, the Fed may need to accelerate asset sales and direct sales in addition to redemptions to return to the pre-pandemic portfolio position. As the Fed's 2017 model tightening reduced balance sheet assets by $50 billion, this means a more aggressive and rapid tightening.
In summary; The Fed aims to prevent an upward price spiral and a permanent inflation based on deteriorated consumer and producer behavior. In terms of the functionality of the monetary policy, interest rate hikes should prevent this deterioration in expectations, otherwise an increased terminal rate will harm the economy and cause the tightening in financial conditions to become excessive. The Fed's need to act rigidly should reduce inflation as well as catch it. Considering the multiplier effect of even the Fed's 0.25 basis point rate hikes on monetary movements, even a 0.50 basis point shift in the scale is an impressive move.
Therefore, it is clear that inflation needs to fall from projected levels and comply with the Fed's 2% target. The normalization of some excessively increased items and the operation of this year's high base starting from the spring of next year may help inflation to decline from peak levels and moderate. However, the Fed should not make the mistake of being overconfident in items that are expected to improve after the pandemic (used vehicles, housing, services), as well as in items that are expected to improve after the war or periodic impact (energy, commodity inflation categories). Because the argument that inflation is temporary is rotten with new variables.
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