about 2 years ago • 1 min
History suggests the Federal Reserve (the Fed) may need to increase interest rates much more than the market currently expects if it wants to tame the fastest inflation in nearly 40 years.
The chart plots the US consumer price inflation rate (in blue) on the same scale as the Fed’s benchmark interest rate (in pink). The green circles show how, from the 1970s to the 2000s, the US central bank was alway forced to raise the interest rate above the inflation rate before consumer prices started falling back.
With the Fed forecast to start lifting interest rates next year, market indicators suggest investors expect its key rate to peak at about 2% before it starts cutting once again. With US inflation currently approaching 7%, this so-called terminal rate seems remarkably low by historical standards.
Investors are clearly betting the deflationary environment that has held sway since the 2008 financial crisis will continue, and the spike in US inflation will pass as Covid-related supply chain disruption clears. But if those expectations prove overly optimistic, don’t be too surprised if the Fed is forced to hike rates well above the 2% that’s currently priced in – with spillover into stocks, bonds, and other investments the world over.
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