The US Federal Reserve (the Fed) is behind the curve on tackling inflation and will need to tighten policy using a combination of levers like rate hikes and quantitative tightening, according to analysts at global reinsurance giant, Swiss Re.
With CPI inflation amounting to 7% YoY and has remained elevated for much longer than expected, Swiss Re believes that it’s more likely to soften and trend towards 3% further along this year.
The company’s analysts also noted that the slower moving but harder to reverse inflation categories such as rent and wage inflation are on the rise.
The Fed is worried about further inflation effects, for example an increase in wages continues to feed into increases in prices of goods and services.
Although inflation will decline on aggregate by end year, Swiss Re believes the Fed is behind the inflation curve and will need to quickly tighten its policy.
This is because inflation will likely be higher post-pandemic compared to the last ten years, as well as due to the Fed’s dual mandate of ensuring price stability and focus on the tight labour market.
However, Swiss Re noted that the Fed is facing a fundamental problem, in that financial conditions have not reacted much to its communicated tightening plans.
“This is an issue since the whole point of signalling tighter monetary policy is to affect financial conditions and slow the economy, the analysts explained. “Financial markets are pricing roughly four rate hikes for this year, in line with Fed expectations, and quantitative easing will conclude by March.”
Yet US overall financial conditions, a measure of how accommodative financing conditions are for an economy, are close to the loosest on record.
Since the Fed’s hawkish turn in December, US credit spreads, equities and the trade-weighted USD have all contributed to looser, not tighter, financial conditions.
If this does not change soon, the Fed may have to face forceful quantitative tightening (QT), but this could risk a policy-induced market shock.
