Further evidence on global tightening

An IMF blog informed us about the alternative indices developed by regional Federal Reserve banks in Cleveland and Dallas. They both aim at measuring “core inf lation”. The usual core inflation yardsticks strip out energy and food.

However, the traditional core inflation indices may no longer be relevant. They date back to the 1970s when global oil prices spiked twice. The new measures filter out either the most volatile prices or cluster around the median price changes. Items whose prices are extremely volatile are being filtered out each month.

They both indicate that the U.S. core inflation may be higher than the official print. In other words, the underlying inflation as trend may be higher than envisioned. Moreover, the two regional Feds also submitted evidence that shows the new core inf lation indices are better in line with indicators of economic slack than the traditional yardstick.

This suggests that a higher Fed policy rate is warranted. Indeed, Goldman Sachs picks up from there and suggests that 7 price hikes in Q1 2022-Q3 2022 are in the making. This means that the Fed’s policy rate could reach 2 even before Q4 2022, and eventually settle at 2.5-2.75 in 2023. An earlier balance sheet reduction move is also likely. This implies something like a shock to global interest rates even though the direction of the move is anticipated. It is one thing to go slowly, but it is quite another if you move fast. Because the Fed’s balance sheet is almost as important as its interest rate, this earlier-than-expected monetary policy move could trigger a further sell-off wave in the EMs. TheUSDTLexchangeratewas7.4inthebeginningof2021; now it stands at 13.6. Some people might think “well, this isallthereis”.TheLiradepreciatedsosteeplythatpeople mightnormallythinkitshouldstabilizeaftertheseverehit. Itlookslikeitdid,butdiditactuallystabilize?No,because the USDTL rate is only kept “low” at around 13.5 today as a result of continual intra-day FX interventions.

There are two factors that will necessarily take their toll. First, the inflation gap between the U.S. and Turkey is huge. It will be, on average, at least 30 percentage points throughout 2022 despite the fact that current U.S. inf lation is quite high by American standards. This means the Lira appreciates every day against USD even though the nominal exchange rate stays the same.

Second, when the Fed begins tightening next month there will be a fast and significant impact. The Turkish CDS could reach further heights, and Eurobond yields might rise.