Stagflation… Inflation is now taken for granted in terms of major economies and monetary policy perspectives. The question of basic policy making is about which question should be prioritized. Because the phenomenon of stagflation, in which inflation and stagnation are intertwined, seems to challenge the economies in the coming period. In such an environment, the markets are at the stage of analyzing the effects of the point where the Fed will bring the market to the economy. The compatibility of the Fed's interventions in inflation with the target path and their reflections on the economic recovery phenomenon is our main concern. The last geopolitical crisis has completely put the growth and inflation balances at risk.
US 5-10 year bond yield spread development… Source: Bloomberg
Tightening in the inflationary environment… The jump in inflation means that monetary policies are now less loose, and the decrease in the effect of the pandemic means that fiscal policies are less loose. In this environment, the Fed is willing and determined to tighten financial conditions. The case in question is important in terms of; The first will be the impact on demand, employment, production trends in the economy, and the second will be the financing costs and firm profitability that will affect all these. Firms whose borrowing costs will increase will naturally increase their resource costs for investment. Due to this strategic uncertainty as well as factors such as excessively volatile input inflation, the Fed should not make any progress that would cause additional demand and production shocks on the economy.
Rational basis… Interest rates are still negative in real terms. Income increases also remained in negative territory in real terms. Prices have normalized in the pandemic-related sources of inflation, it's true. However, there is movement in cases related to supply shortages and geopolitical risks, and they create serious uncertainty. In an inflationary environment, this phenomenon increases the risks of recession and causes compression in economic dynamics. Developed countries, especially the US, have to observe the dynamics firmly in terms of acting in accordance with the conjuncture. They will expect to see some images in the numerical data. For example, it is necessary to extract the projection direction as well as the current status of activity data such as ISM or PMI. In all of these, they have to monitor the status of input costs in terms of price components. When inflation hits private consumption by exceeding certain thresholds and spending allocations concentrate on basic needs, many sectors will also reduce production under these conditions. Tightening can also harm growth, and inflation too. The rationality of handling inflation in the Fed perspective is based on the fact that stagflation is inevitable if price increases are not brought under control.
Conclusion? In an environment where inflation is +8%, the Fed will need to raise interest rates by many 50 bps to catch up with these rates. Of course, in order for this tightening not to be too damaging, inflation must be able to fall to the target path. Bullard's guidance of 75 bps was a little interesting, but while the Fed would have enough multiplier effects even with 50 bps, it would be an extraordinary decision to make a rate hike traditionally beyond that. The Fed normally does not go beyond the rates and expectations that the market takes for granted. While the Fed is advancing rates, an environment that has already seen the peak of annual inflation and is in a decline allows it to move much more easily. It is no longer a problem if the Fed raises interest rates by 50 bps, if the next steps will be effective with 25 bps, it will be fine.
75 bps is very extreme, This means that long-term funding should rise above 3% in this long-term projection. It makes more sense for the Fed to start with 50 and move forward on a case-by-case basis. Divergence with the ECB or other central banks are also deepening, which is in favor of the dollar in the currency basket. The 10-year yields need to breathe, the up-down price axes are asymmetrical, so the up margin decreases, and the downside effects may be deeper from now on. Such an interest rate easing is only possible with the maturation of more dovish expectations.
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