Most investors and bankers miscalculated how quickly inflation would rise last year. Is history repeating itself?

Most American investors and central bankers miscalculated how quickly inflation would rise last year. They may now be underestimating just how high interest rates will have to rise before it starts to decline again.

The US economy and financial markets started the new year well despite the Federal Reserve's most aggressive campaign of credit tightening in four decades. Retail sales, payrolls, and equities prices all increased sharply.

Further rate rises from central bank chair Jerome Powell and his colleagues to calm things down are likely given the sticky inflation rate that is now running well above the Fed's 2% objective.

Bruce Kasman, the chief economist at JPMorgan, asserted that there is a good probability the Fed would act more proactively than the markets anticipate.

The possibility exists that when people drain the financial reserves they built during the pandemic, tighter credit will finally catch up with the economy and cause a recession.

Households have been able to endure rising prices and borrowing costs thanks to excess savings—Mark Zandi, chief economist at Moody Analytics, estimates there is still $1.6 trillion in them—and a thriving employment market.

On how far the Fed will hike rates during this tightening cycle, investors have already increased their bets. Trading in the US money markets indicates that they currently anticipate the federal funds rate to increase to 5.2% in July. This contrasts with the apparent top rate of 4.9% that occurred only two weeks earlier and the current goal range of the central bank, which is 4.5% to 4.75%.

Preparation

The terminal rate, or the greatest point that the Fed will reach, is being revised upward by economists. Matthew Luzzetti, the head of US economics at Deutsche Bank Securities, increased his prediction this week from 5.1% to 5.6%, citing a strong job market, more hospitable financial conditions, and higher inflation.

Also sounding more hawkish are Fed officials.

President of the Federal Reserve Bank of Dallas Lorie Logan stated on February 14 that "we must remain prepared to continue rate increases for a longer period than previously anticipated, if such a path is necessary to respond to changes in the economic outlook or to offset any unwanted easing in conditions."

The median prognosis made by Fed policymakers during their most recent round of forecasts in December was for a peak rate of 5.1% this year. When the Federal Reserve announces updated estimates next month, observers said they wouldn't be shocked to see a higher number.

Ken Rogoff, a former head of the International Monetary Fund's economic department, said this week on Bloomberg TV that he wouldn't be shocked if interest rates ended up at 6% to combat inflation.

Too Soon To Relax?

The disinflationary process has started, according to Powell, but the path back to the Fed's aim will be difficult and drawn out.

The labour market has been singled out by the Fed chair as a possible source of inflationary pressure. He argues that demand for employees is outpacing supply and that pay growth is too rapid to be consistent with the Fed's 2% price target.

While unemployment has decreased to its lowest point since 1969, payroll growth over the past three months has averaged 356,000 per month, far beyond the 100,000 Powell claimed is compatible with stability.

Since it was so difficult for businesses to hire more personnel when the economy emerged from pandemic lockdowns, employers have been reluctant to lay off workers. As the large Baby Boom cohort of workers continues to retire, the labour market will also experience longer-term structural constraints.

(Investing.com, Bloomberg.com, Reuters.com)