In a sign that the US Federal Reserve is shifting to tighter monetary policy, Fed chief Jerome Powell told Congress last week that it is “probably a good time to retire the word” transitory when talking about inflation within the US economy. He announced that inflation is probably more persistent than expected and that in response, the Federal Reserve may have to reduce its support plan for the economy faster than originally expected.

Powell’s abrupt change of tone, just a few days after his renomination by President Joe Biden, came as a shock to markets as stocks slumped (particularly tech stocks), short-dated US government bond yields rose and commodities fell. It didn’t help either that Powell timed his statment at a time when markets were trying to assess what the emergence of the new Covid variant Omicron meant for economic activity.

The reference to transitory inflation first appeared in the Fed’s policy statement in April and was meant to convey the expectation of a short spell of higher year-on-year inflation readings driven by base effects – or the comparison with pandemic suppressed data in the previous year. Many have taken issue with his thinking, given that Powell himself has acknowledged that inflation is proving more powerful and persistent than expected. Moreover critics argued that the massive monthly purchases of market securities were becoming increasing incompatable with the improving state of the economy and at a time when markets were showing growing signs of excessive risk-taking.

The Fed’s change of hearts flows from supply chain disruptions and demand and supply imbalances that have proved to be far more entrenched than the Fed had evisaged and which have flowed into increased energy, housing and wages costs, factors that Mr Powell has indicated, would “linger well into next year”. It was only last month that the Fed began tapering the US$120 billion a month of bond and mortgage purchases that were at the core of its emergency response to the initial outbreak of the pandemic last year.

Powell’s testimony to Congress suggested that the Fed is now shifting its focus from being worried about a faster labour market recovery toward being more concerned about keeping a lid on prices. In fact, after Mr Powell’s remarks, money markets moved quickly to estimate a 50/50 chance that the Fed will hike rates as early as May. Moreover, they are now pricing in around 60 basis points of increases by the end of next year. Until now, the Fed had always been careful to separate tapering and interest rates rises. It will probably continue to do so by insisting that the emergency stop of money printing will help calm inflationary pressures.

The extent to which the Fed and its peers elsewhere will raise rates is likely to be constrainted by the big increases in government and household’s debt levels during the pandemic. Relatively small increases in interest rates could have significant adverse consequences within real economies, which might help limit the extent of the threat to financial markets.

Disclaimer: This article was written by Stephen Borg, Head of Private Clients at Calamatta Cuschieri. The article is issued by Calamatta Cuschieri Investment Services Ltd and is licensed to conduct investment services business under the Investments Services Act by the MFSA and is also registered as a Tied Insurance Intermediary under the Insurance Distribution Act 2018.

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