Recession, stagflation, inflation… With the recent Russian occupation of Ukraine, the economic uncertainty surrounding it, and the flattening of the yield curve, fueling recession concerns, the Fed has also entered a critical juncture. However, if we consider that the dynamics that will cause recession is actually a stagflation cycle that will completely encompass it, the Fed should either provide a soft transition that does not harm the growth dynamics, or provide a cyclicalization that will reduce inflation sufficiently in order to achieve critical policy targets. The mainstays of the March 16 decision will show us where the Fed will go.
FOMC December 2021 economic projections: medians, central trends, and economic forecast ranges for PCE and core PCE, for 2021–24 and longer term… Source: Federal Reserve
Comparison of inflation and interest rates… As we can see from the surreal details in the ECB decision, it is seen that central banks have a continuity problem in following the inflation and yield curves. Steps to revitalize the economy, with the contribution of financial incentives, opened the process towards growth. At this point, although the resulting inflation was not caused by policy, the curve update brought about by current inflation also had a distorting effect on future inflation expectations, and the interest curve did not follow this on a nominal basis. Therefore, this is the reason why central banks cannot escape the reality of inflation despite current economic risks. The Fed will therefore have to establish a tightening cycle, albeit balanced.
Economic forecasts… Rising commodity prices are already creating a challenging price environment for consumers and businesses. It is obvious that this increase will gain more momentum with the Russian crisis. This means that it will take longer for the inflation to fall cyclically in the future to reach the equilibrium point and the policy target. A 50 basis point increase is unlikely as growth will slow. New economic projections from FOMC members will also be announced at this week’s meeting, helping to shed light on how the Committee expects to balance current pressures on growth, inflation and a labor market recovery that continues to beat expectations.
It is likely that the GDP will undergo a limited downward revision, while remaining positive and close to average values, inflation forecasts will be raised and unemployment forecasts will not be subject to much revision.
Fed effective interest rate and inflation comparison… Source: Bloomberg
The degree of tightening, balance sheet and stagflation phenomenon… FOMC members have signaled that they want to raise a few interest rates before shrinking the balance sheet, so we do not expect any changes in balance sheet policy at this meeting. Rising inflation and flattening yield curve make policy more difficult because we are faced with an intertwined phenomenon of inflation and recession. Since the current economic balances are compared to the 1970s, there is concern about the shrinking effect of the rapid monetary tightening on the economy. The bond market will be very active due to the war and accordingly the value of American bonds on the balance sheet will change. Here is the critical fact; Bonds whose interest rates increase with inflation and their value decreases? Or bonds that are in demand and rising in value due to the risks of war?
Conclusion? It seems that the Fed’s sphere of influence will operate separately for headline and core inflation, and core trends are more important in approaching the target in terms of demand, wage, and credit-driven inflation. Food and energy, which are the main items affecting the headlines, are heavily dependent on non-Fed factors. This effectively excludes the 2% target on average for how far inflation can fall. The Fed’s interest rates are quite low compared to inflation and inflation expectations. This causes the Fed to still consider raising rates despite the current geopolitical and supply chain risks.
Kaynak: Tera Yatırım
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