The Fed must control inflation but this is no easy task

Consumer and business expectations play an essential role in the economy. There is underlying psychology that tends to affect activity. For example, if people expect higher prices in the future, they may accelerate purchases to circumvent the price increase. At the same time, businesses may frontload price increases in anticipation of inflation.

Moreover, when one considers wage negotiation in such an environment, another layer of complexity is added. In effect, a self-fulfilling loop is in the making. If not anchored, it may spiral out of control. The Fed is being aggressive in policy to disrupt this process and ensure that market expectations are firmly anchored with limited scope.

Average hourly earnings printed at 0.4% m/m last Friday, 5% annualised. Moreover, the US inflation rate is rampaging at 7.9%. If these continue to rise, the loop described above may gain traction. Supply shocks have exacerbated this potential spiral due to Russia's invasion of Ukraine on 24 February.

Last Friday also cemented a strong jobs market, with 431,000 jobs created in March and unemployment dropping to 3.6% (U3). Given the worry that inflation may spiral out of control, the Fed hopes that the robust jobs market will give them room to pursue their aggressive policy, with only minor and temporary consequences.

However, the central bank has a complex task ahead of it. It needs to navigate potential stagflationary pressure, run off its balance sheet without disrupting the housing market, and pace the liquidity drain to minimise disruption.

Featured image by Gerd Altmann from Pixabay

Russell Shor

Senior Market Specialist

Russell Shor joined FXCM in October 2017 as a Senior Market Specialist. He is a certified FMVA® and has an Honours Degree in Economics from the University of South Africa. Russell is a full member of the Society of Technical Analysts in the United Kingdom. With over 20 years of financial markets experience, his analysis is of a high standard and quality.

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