The US Federal Reserve has finally acknowledged the reality of the inflation problem. The uncertainty raised by the Russia-Ukraine war did not stop it from raising rates at its March policy meeting, though it capped its first hike to just 25 basis points.
Connecting the "dots" points to an expected total of seven rate increases this year, and Fed Chair Jerome Powell indicated that quantitative tightening (shrinking the Fed's bloated balance sheet) will start sooner than expected, likely in May.
This might all sound rather hawkish. Inflation had become a major social and political problem, and Mr Powell tried to channel former chairman Paul Volcker, signalling the Fed is aggressive and determined to bring inflation under control.
But compared to the magnitude of the inflation challenge, I believe the Fed's stance is nowhere near as hawkish as it should be -- though it sounds very hawkish compared to its previous implausibly accommodative line.
In previous tightening cycles, the Fed has had to lift the policy rate above inflation to bring price dynamics back under control. Today, the policy rate is barely above zero while headline consumer price index (CPI) inflation is close to 8%. The core personal consumption expenditure (PCE) index that the Fed prefers to use stands at 5.2%.
Even another six rate hikes -- if they include just one 50-basis-point bump in a series of predictable 25 bps increments -- will still leave the policy rate under 2%. The Fed expects the policy rate to peak at 2.75% next year; only then, in the Fed's view, would it exceed core PCE, which it projects will have dropped to 2.6%.
The Fed's "hawkish" stance, in other words, is mostly wishful thinking. It still assumes this inflation surge will self-correct and that inflation will come back to target even as the real interest rate remains negative throughout this year and for part of next year as well.
UNPLEASANT ARITHMETIC
Here is an update of the unpleasant inflation arithmetic that I like to use: headline CPI inflation -- which is what matters for consumer behaviour and wage-setting -- averaged 0.7% month-on-month for the last six months, and 0.6% for the last 12.
Let's be optimistic and assume it will average just 0.4% from March through December. Headline inflation would end the year at 5.6% -- three times higher than the projected end-year policy rate.
Core PCE averaged 0.4% month-on-month over 2021; if it keeps that pace, it will end the year at 5%. If headline CPI keeps the pace of the last 12 months, it will end the year close to the latest reading, at 7.7%. Real interest rates would remain deep in negative territory.
How can we expect inflation to behave in the coming months? Let's take the pulse of the underlying macro situation. The US labour market remains extremely tight and cost of living adjustments, where wages are automatically indexed to past inflation, are making a comeback because inflation has consistently outstripped forecasts for too long.
Geopolitical uncertainty has caused energy prices to surge, put pressure on other raw materials and caused further disruptions to supply chains. A rising preference for self-sufficiency in key industries will become a significant long-term inflationary factor.
A number of self-sustaining inflationary forces have been set in motion -- abetted by the continuation of an exceptionally loose monetary policy that, in combination with a record surge in government spending, has proved to be a major policy mistake.
NOT JUST SUPPLY SHOCK
To be clear, inflationary supply shocks are playing a role here -- but they are certainly not alone. When a supply shock pushes up inflation, a central bank must assess the risk that it will trigger "second-round effects" -- price and wage increases that will propagate and amplify the shock.
Only if this risk is significant should the central bank react and raise rates; otherwise, it should wait for the supply shock to fade.
But in the current case, extremely loose fiscal and monetary policy had already been fuelling inflation since the post-pandemic recovery started; they are an important source of inflation by themselves, and moreover, they make it inevitable that any supply shock will quickly trigger second-round effects that make its inflation push self-sustaining.
To expect that inflation will now come back to target on its own -- even if higher prices and geopolitical uncertainty cool off economic activity -- is foolhardy.
To bring inflation under control, the Fed will need to undertake much more aggressive policy tightening than it currently envisions. To see it through, it will need the courage to withstand substantially higher volatility in asset markets, which might include painful corrections.
The Fed has taken the red pill and seen the inflationary reality we live in; but like Neo in The Matrix, it will take longer to fully recognise what it will take to bring inflation under control.
Sonal Desai is chief investment officer with Franklin Templeton Fixed Income