Monetary Tightening Perspective in Line with Inflation

Inflationary pressures… While inflationary pressures were felt intensely in the US, the May CPI data released on Friday showed that inflation was not on the decline as it was thought, but on the contrary, its upward trend continued. In May data, the CPI increased by 8.6% year-on-year, while the core CPI indicated an annual rate of 6%. Such high realizations fuel hawkish expectations, as we know the Fed will remain on the brink of raising rates quickly unless the CPI shows any obvious signs of weakening. The widespread and multi-pronged trend of inflation is challenging for the effectiveness of the necessary policy action. At this stage, factors such as supply chain problems and the acceleration in services inflation point to an inflation that may remain high for a long time and highlight the cumulative risks in this direction.

Hawkish perspective… While it is understood that the inflation trend is still not going down, it is obvious that the determinations regarding the temporaryness of inflation in the previous period are a “misreading”. Accordingly, more expectations arise for an accelerated tightening on the Fed’s side. While it seems certain that the Fed will start the series of 50 bps rate hikes this week, it is almost certain that it will continue it this way in two more meetings. Powell’s latest statements show that 50 bps rate hikes at the June and July meetings are considered reasonable. The guidance is for the Fed to raise rates until there is a sustained and convincing drop in inflation and to quickly reach a neutral rate. The FOMC minutes also revealed that many members had a viewpoint in line with this route.

Comparison of US headline CPI and core CPI… Source: Bloomberg

Economic activity reservations… The Fed’s threshold of avoiding rate hikes within the framework of declining economic activity is not yet certain, and it is still unclear whether interest rate hikes will lead to a recession. While the latest consumer confidence data show the erosion effect of inflation on the willingness to spend, there is a risk that the US economy will experience a demand shock from price increases or financial tightening. Although this perspective highlights the analysis that it might stall in September, the necessity to reduce inflation and the profile shifting to demand inflation show that the Fed is more likely to not be shy in applying bitter pill.

A monetary authority, such as the European Central Bank, which stands closer to the recession potential in the crisis environment created by geopolitical risks, has also revealed its desire to proceed on the tightening route. Revealing the hawkish perspective in its last meeting, the ECB gave the signal for a 25 bps rate hike in July, while also putting the possibility of a new rate hike on the table at the September meeting.

Conclusion? The higher-than-expected inflation data and the high price effects also reflected in the core indices. US 2-year bond yields 3.21% and 10-year bond yields 3.25% weighted the upward movement, reflecting a front-loaded tightening effect. These levels are also important in terms of crossing the peak market interest rate threshold in 2018. The Fed will likely be quicker to make policy adjustments that more tightly address credit markets and demand in the economy, and the inflation implications of incoming data could potentially have an impact on generating marginal expectations.

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