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The US Federal Reserve has said the rise in inflation is transitory, but Nomura believes that the central bank could be wrong. Fed’s own diffusion index of Federal Open Market Committee (FOMC) participants’ risk weightings on their core personal consumption expenditure (PCE) projections is at its most elevated since the survey first began in October 2007, the Japanese firm notes.

“The reverse sequence of inflation rising well above target before the full employment goal has been achieved is not particularly well suited for the Fed’s new monetary policy strategy that has prioritized achieving maximum employment," said Rob Subbaraman, head of global macro research and co-head of global markets research, Asia ex-Japan, Nomura in a note.

Series of supply-side shocks – from shipping to semiconductors to now energy – combined with still-significant policy stimulus and the reopening of the economy could push the unemployment rate low enough to boost wage inflation and de-anchor longer-term inflation expectations, according to Nomura.

At the September FOMC meeting, the participants seemed cognizant of this risk, for while their median projection was for core PCE inflation to drop from 3.7% in 2021 to 2.3% in 2022, 13 of the 18 participants saw the balance of risks to their projection weighted to the upside, he said.

Subbaraman argues that if the Fed turns out to be wrong on transitory inflation, it would be a significant blow to its credibility; to re-establish its inflation-fighting credentials the Fed would need to hike rates sharply to catch up, as suggested by monetary policy rules. “And herein lies the Fed’s policy dilemma," he said.

He feels that a much faster-than-anticipated Fed rate hiking cycle would have serious international spill-over effects.

First, higher US interest rates would quickly transmit into higher interest rates across the globe. Among the major central banks, the Fed has been one of the most dovish – strongly advocating that the high inflation is transitory.

Subbaraman adds that faster Fed rate hikes would likely translate into a stronger US dollar, adding to the upward pressure on inflation outside the US, some emerging markets countries might need to hike rates to punitive levels to stem capital flight and currency depreciation.

“And second, public and private debt loads, which were already high before the pandemic, have risen substantially, meaning that sharply higher interest rates would have a more detrimental impact on the global economy than before," he said.

Though interest rates are currently still at very low levels, private sector debt-service ratios – ratio of interest payments plus amortisations to income – are not that low compared to historical levels, precisely due to the surge in debt lifting interest payments.

Nomura estimates, the US debt-service ratio would shoot up from 13.7% currently to 17.8%, which is similar to its level 13 years ago, just before the global financial crisis. In countries outside the US, the escalated cost of servicing debt would be even more of a shock. For many countries, the private debt service ratios would be the highest they have experienced in a very long time, Subbaraman warns.

He feels that sharply higher debt servicing costs while economies – particularly in emerging markets – are still recovering from the pandemic would be a major setback, and would likely put credit markets, banks and government finances under considerable strain.

“If the Fed is wrong on transitory inflation, it has no good policy choices. …In our view, the Fed being unwilling to fight persistent inflation is a very low probability, but a high risk outcome, as it would shatter the Fed’s hard-earned credibility. Nonetheless, it cannot be completely ruled out," Subbaraman said.

The Fed, caught in a debt trap, could struggle to raise rates over concerns of triggering a financial market crash that tips the economy back into recession. America’s loss of policy credibility could cause the US dollar to start losing its reserve currency status, he added.

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