In the period when we follow the uncertainties of the economies related to inflation, we will look for new policy clues while watching the reservations about the Covid-19 Omicron variant. In this environment, hopes that Omicron may be less harmful to the economy than previous variants support our expectations of steering it towards tighter policy ground. The Fed's new ground is clear, as Powell also influenced the markets with his more hawkish comments, with the framework brought by the latest economic data and high inflation. We wonder how tight and how fast?
In his speech at the end of November, Powell adopted a more hawkish tone, emphasizing his intention to put his 'temporary' view on inflation out of circulation, revealing that the Fed would consider accelerating a reduction in asset purchases. So right now we're concentrating on the details of the duty. The market will question the linearity and succession of the Fed's rate hikes, and current data also support the rate hikes before 2023. This will of course have volatility regarding the new terms, but the market is now more intensely considering the transition to a liquidity composition with no asset purchases. If the threats from the Omicron variant are going to be minimal or not overburden the economy, it's perfectly normal for them to think so. The situation is not really about the full recovery of the economy, but about the priority order of its problems. The threshold to avoid policies that would bring further inflation is currently being addressed, as control of inflation is seen as urgent and important. In this regard, we expect new directions from the FOMC that we did not have before.
US 10-year bond yield, 5-year break-even inflation expectations, CPI comparison… Source: Bloomberg
Despite all this, when we look at the yield of the 10-year Treasury bond, we are at the level of 1.43% as of today. This actually brings us to the following point, when we adjust it with 6.8% inflation, there is no harmonious trend in the transition from short-term to long-term. The Fed also sees the long-term equilibrium interest rate as 2.5%. In other words, the rate predicted after 2024 in terms of the Fed funding rate. At this stage, at the point of convergence of interest rates, the inflation for the period should approach the 2% target in order to bring the adjusted returns to a reasonable level. In the function of increasing interest rates, policy tightening can both spread the effect of short-term interest rates and increase real yields, and also contribute to the decrease in inflation.
At the factorial divergence point, it is necessary to consider the interaction of short-term and long-term interest rates. Inflation is high in the short term, probably out of the temporary effect. At this point, the prediction that inflation will remain high only in the short term due to non-temporary factors does not go very far. Therefore, this orientation also needs to be changed. There are moderate increases in inflation break-even rates in 5 and 10-year maturities, higher inflation expectations may also be reflected in the long-term movement. Expectation management is important in that, as a result, if individuals expect inflation to rise, they spend more, which leads to inflation warming in the short run. The longer the expectation deterioration spreads, the more inflation the expectation creates. We think that the FOMC will not allow this cyclical disruption and will accelerate the transition to tighter policy, relying on the improvement in the unemployment rate.
The Fed has two goals in theory and practice: maximum employment and 2% inflation in the long run. The annual rate of PCE inflation, the Fed's preferred measure of consumer price inflation, has exceeded 2% since March. Moreover, the PCE inflation rate is expected to continue to exceed 2% until mid-2023. At the point of employment, there is still a deficit compared to the pre-pandemic cycle. On the other hand, we have the lowest unemployment rate of 4.2% in the post-pandemic period, 0.7 points above the pre-pandemic level of 3.5%. In this economic cycle, especially the hotter-than-expected increase in inflation leads us to expect that the QE dimension, which was reduced from $120 billion to $105 billion in the first place, will begin to decrease faster than $15 billion. Tapering circularity can also be expected to witness even faster interruptions after January. Therefore, we expect all asset purchases to be completed by March or April 2022 at the latest. This means that the FOMC may take the first interest rate step at the end of 2Q22 or the beginning of 3Q22, and the second rate step in 4Q22. In 2023, we expect this cycle to accelerate and the Fed funding rate to reach 1.25%.
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