IMO the market is strongly underestimating the magnitude of rate hikes required to temper inflation

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by jalalipop

Across the new sources I read, the consensus seems to be that the market is pricing in the first rate hike around Summer 22. The magnitude of the expected rate hike is tiny, maybe a quarter-percent. If you are of the belief that supply-chain shortages will last well into 2022, this is hilariously inadequate.

First, we’ve seen from 10 years of monetary experiments that the direct relationship between inflation and the state of the economy + monetary policy is tenuous at best. And this has benefitted the economy at large as we have pumped more and more money and cheap debt into the system with no apparent ill effects (except the ones that we choose to ignore, but I’m not here to beat that debt horse!). So it’s already ridiculous to believe that the converse won’t also be true. A 25 basis-point increase will do nothing to temper inflation.

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Second, we have a new phenomenon that does seem to have a strong connection to inflation, both in theory and in practice. Inflation expectations among spenders and workers are higher than they’ve been in over a decade, wage increases at the bottom are faster than they’ve been in over a decade, and supply chains are more constricted than they’ve been in a decade.

Thus, if inflation persists, even at the not-hyper-inflation levels we’re currently seeing, it’s not a stretch to see that the Fed will have to make moves that shatter the confidence driving the second point. Once you accept the first point, that the Fed’s tools have a weak causal relationship with inflation, it’s clear that the only way they can stop inflation is to raise interest rates enough to tank assets, which will shake consumer confidence and bring demand in equilibrium with supply. If that isn’t enough, they will be forced to go further and cause a recession, although this will take a lot of pushing, given their need to balance against the full employment mandate. Either way, I think we can all agree a quarter rate increase will do nothing.

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I’m curious what other people’s thoughts are. I’m not making any earth-shattering new statements, just connecting dots. To me, this outcome flows logically from the two points above, if you believe that higher inflation (but not hyper-inflation) will be persistent into next year.

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