Inflation has been an ongoing concern in 2021 and now into 2022. The past year saw inflation reach multi-year highs for the US, Eurozone, and in countries like Spain. It climbed to 7% through December of last year. In 2022, the same narrative is expected to continue.

However, the US Federal Reserve (FED) is likely to take a more aggressive stance to curb the soaring inflation.

In the United Kingdom, the Bank of England has already raised interest rates, and it's also likely that other Central Banks like the European Central Bank will follow suit.

So, are these financial institutions pushing the panic button too quickly, or are they making the right call?

Why is inflation so high?

The inflationary burst the world experienced last year has been driven partly by two significant factors - partly by demand and supply and partly by the pandemic.

On the pandemic side, the Coronavirus caused a lot of factories to shut down, causing significant supply chain problems. The result was a limit in the supply of goods, pushing prices higher.

But it is also the case that consumers were collectively building up their savings thanks to months of quarantine and repeated government stimulus checks, AKA Fiscal Policy. As such, consumers have been on a spending spree, and their demand is also driving part of the inflation. What's more, their wages have been going up, as seen in the 4.8% increase in November compared to 2020.

A Worst case scenario

High inflation rates typically spell potential trouble for financial assets, said Aswath Damodran, a Corporate Finance lecturer at New York University's Stern School of Business.

If the inflation rates continue to rise, investors will need to make higher returns to break even. Before the inflationary burst, a 5% annual payback on your investment might have been attractive in early 2020. However, once inflation has taken off like we are currently experiencing, your investment would actually be declining in terms of real-world purchasing power.

Moreover, inflation can also be tough for the underlying companies, especially those lacking pricing power. These sorts of companies tend to suffer the most since they are forced to absorb the increase in production cost. They end up taking a hit to their profit margins and stock prices, as stated by Dr. Sunil Kumar Sinha, Principal Economist and Director of Public Finance at India Ratings.

Did the FED wait too long to address inflation?

Last month, in a sharp pivot towards combating inflation, the FED signaled that it would likely raise its short-term benchmark rates four times. However, some economists warn that the FED may have waited too long to reverse its ultra-low policies. By waiting too long, the FED might be forced to accelerate its rate increases or even press harder and sooner on the economic breaks. This would slow economic growth, lead to mass unemployment, disrupt markets, and potentially cause a recession, as witnessed in the aftermath of the 2007-2009 Great recession.

According to Tim Duy, chief U.S. economist at SGH Macro Advisors, there is a significant risk that the FED might be behind the curve. It might be forced to let inflation remain persistent or risk a recession.

Moreover, a recent survey conducted by Tomas Havranek and Marek Rusnak for the International Journal of Central Banking shows that the average lag time to reverse high inflation rates is averagely 29 months, which means that high inflation rates might persist until 2025.

Does Chad Stone, Chief Economist at the Center on Budget and Policy Priorities, have a different view?

Chad believes that the current inflation stems primarily from COVID-related disruptions in the supply chain and a pandemic economy and not from an overstimulated economy. He also states that global nations will need to contain the virus to keep the economic expansion and lower inflation rates.

Final thoughts

The high inflation rates are likely to persist as long as consumers receive higher pay. Higher pay means more spending, keeping upward pressure on prices.

Also, if the FED maintains a slow and steady Quantitative tightening, the high inflation rates might persist into 2023 and 2024. On the other hand, if the FED becomes more aggressive on Quantitative tightening, investors are likely to see the economy slow down. As a result, it appears that the inflation crisis is more in the red zone than most investors might realize.

Disclaimer: This information is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration for your personal investment objectives, financial circumstances, or needs.

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NAGA Group AG published this content on 18 January 2022 and is solely responsible for the information contained therein. Distributed by Public, unedited and unaltered, on 24 January 2022 12:53:07 UTC.