Weekly Update - US to speed up monetary tightening
Fed drops idea of “transitory” inflation
At Tuesday's Congress testimony, Jerome Powell hinted the Federal Reserve was ready to take a more restrictive approach to monetary policy. Powell repeatedly said it would be appropriate for the 15 December meeting to discuss a “a somewhat faster taper” perhaps “to consider wrapping up the taper of our asset purchases… perhaps a few months sooner”. The Fed had already announced a USD 15bn monthly wind-down of its purchase programme back at its November meeting. Powell justified the change saying that “the economy is very strong and inflationary pressures are higher” and that “the threat of persistently higher inflation has grown”. Accordingly, the Fed has abandoned its core assumption of high “transitory” inflation driven by post-Covid normalisation of the economy, raising the chances of multiple rate hikes in 2022.
More widespread and more political inflation
Powell's change in tone comes against a backdrop of ongoing high US inflation, where non-transitory factors are starting to build. Inflation in the stickiest goods and services was running at 3% in October, and the trimmed-mean index, which strips out volatile components, at 4%. Furthermore, consumers and businesses continue to expect inflation to remain high (above 3%) in the coming quarters. Finally, high inflation is starting to affect households. Consumer confidence surveys are weakening despite a still dynamic labour market. Overall, in a context of more widespread and politically sensitive US inflation, it seems likely the Fed will again prioritise its price stability mandate over its mandate to maintain full employment.
Bond market betting on stable inflation
While short rates naturally bounced on the testimony, long yields actually fell, resulting in a flattening of the sovereign yield curve. Bond markets seem to be betting the peak of the tightening cycle will be lower than last time around. Interesting to note, the market's inflationary expectations remain stable (5Y5Y forwards at 2.25%) in contrast to surveys of household expectations.
As inflation continues to show signs of an uptrend that can no longer be called “transitory”, central banks are striking a more hawkish tone. The Fed is set to announce an acceleration in tapering and launch a gradual cycle of rate hikes in H2 2022. In the euro zone, inflation continues to surprise on the upside, driven by energy prices. The ECB could announce the end its Covid asset purchase programme but its overall policy stance should remain accommodative, maintaining its classic asset purchases and bank facilities. Overall, the scenario is good for the dollar.