Slaying the Demon of Inflation… the Priority

All eyes are on the next meeting of the FOMC due on 14th and 15th of June, almost three weeks from now. It is not without reason that this attention is given to the event. The Fed’s decision on rates affects everything around the world. That is the perception and the reality. It is almost a forgone conclusion that the Fed is going to hike again in the next meeting, and the only difference of opinion is on the quantum of the rate hike. But the language and tone of the last statement reveals an extra ordinary concern on the price level and the need to bring it down as soon as possible. The statement read like this – “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” It also makes a reference to the Russian invasion of Ukraine and the Chinese pandemic situation, and the potential effects of the two events. “The invasion and related events are creating additional upward pressure on inflation and are likely to weigh on economic activity. In addition, COVID-related lockdowns in China are likely to exacerbate supply chain disruptions.” It is less likely that the Fed policy is going to be any soft especially in view of the attack on the Fed for delaying the much-needed pre-emptive rate strikes before inflation accelerated. More than the rate action, the decision to reduce the size of the Fed’s holdings of treasury papers and also mortgaged backed securities is yet another factor that would enhance the speed of normalization of liquidity because any excessive holdings will either dilute or at least truncate the effectiveness of policy.

Even as US inflation picked up, post the peak pandemic, the implications of high inflation for US equities was presented in the global macro update a couple of times. It was the results of study covering four decades of US equity markets. The finding of the study was that beyond an inflation rate of 3 % to 3.50 % and which sustains for a few quarters, the equity valuations would drop drastically over time. Without an iota of doubt, it can be stated that it is this very same phenomenon that is at play. It propels a whole lot of things, the strength of the Dollar, the US Dollar currency yield, the relative positioning of emerging market currencies, the prices of commodities like gold, asset movements, equity valuations, and growth itself. Therefore, for the policy makers slaying the demon is the priority.

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