Amid rising concerns over inflation, it has become increasingly evident that the U.SFederal Reserve faces a daunting challenge as it navigates through the complex interplay of demand, supply, and monetary factors fueling this economic phenomenonThe reality is, even if the Federal Reserve takes stringent measures that could lead to recession and increased unemployment, achieving the elusive 2% inflation target may still be a distant dream—perhaps not for another year and a half.

In May 2022, the Consumer Price Index (CPI) in the U.Srecorded an 8.6% year-on-year increase, marking the highest figure since December 1981. Responding to this alarming figure, the Federal Reserve convened a crucial meeting in June, where it decided to raise the federal funds rate by 75 basis points, pushing it to a range of 1.50%-1.75%. According to the dot plot indicated in this meeting, a majority of members projected that the benchmark interest rate would reach 3.4% by the end of 2022, implying a further 165 basis points increase would be necessary in the latter half of the year.

Clearly, controlling inflation has become the foremost policy goal for the Federal Reserve in this current economic climate

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This surging inflation is reminiscent of the situations faced in the 1970s and 1980sReports from the World Bank suggest that both periods share distinct similarities, especially regarding supply chain disruptions, slowing growth prospects, and the vulnerabilities faced by emerging economies grappling with monetary tightening.

During the turbulent inflationary period of the late 1970s and early 1980s, how did the Federal Reserve manage to control soaring inflation?

In March 1980, as oil prices skyrocketed, the CPI soared to a staggering 14.8%, marking an all-time high post-World War IIUnder the leadership of then-Federal Reserve Chair Paul Volcker, the strategy relied heavily on controlling the growth of the money supply and credit expansion while hiking up the federal funds rate and the discount rate

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Specifically, the federal funds rate surged from an average of 10.1% in January 1979 to a dizzying 17.6% by April 1980, with the monthly rate experiencing an unprecedented increase of up to 310 basis points.

In periods of raging inflation, the Federal Reserve resorted to short-term toleration of economic recession to implement aggressive tighteningThis resulted in GDP contractions across the second to fourth quarters of 1980. In response, the Fed relaxed monetary policy starting in May 1980, with the average federal funds rate dropping by 660 basis points to 11.0% that monthHowever, this easing only lasted three months, with rates bottoming out at 9.0% in JulyAlthough the CPI had retreated from its peak in March 1980, it remained alarmingly high, hovering between 12.5% and 14.5%. Volcker posited that a fundamental shift in inflation expectations could only occur if an economic recession were to unfold.

As inflation levels showed signs of falling, the Federal Reserve shifted its focus back to supporting the economy

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In February 1981, they resumed loosening measures, reducing the federal funds rate by 320 basis points to 15.9%. Between February 1981 and December 1982, rate adjustments were frequent, oscillating between cuts and increasesCoupled with the Reagan administration's tax cuts passed in the summer of 1981, U.Seconomic growth saw a rebound in 1981, only to slip back into recession in 1982. Following this, the economy rebounded from 1983 to 1989, with inflation curbing itself below 5%. The Fed's rate policy closely followed the inflation trajectory during this period.

Overall, the decade of the 1980s at the Federal Reserve was marked by vigorous actions, as reflected in an average federal funds rate of 9.91%. These aggressive measures eventually managed to tame the inflation beastThe yield rates on 10-year U.STreasuries moved in tandem with the federal funds rate, exacerbated by the drastic fiscal deficits ushered in by Reagan’s tax policies

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As a result, the supply of treasuries surged, and Volcker's refusal to allow the Fed to purchase U.Sdebt directly meant curbing inflation risk before it could set in—a move that led to an average yield of 10.6% on 10-year treasuries in the 1980sConsequently, this sparked a severe sovereign debt crisis among Latin American countries heavily reliant on commodity exports and external debts.

The current round of inflation, however, poses a grave threat, driven by a convergence of factors.

First and foremost is robust demandThroughout the pandemic, the U.Sgovernment rolled out extensive fiscal stimulus policies that bolstered household consumptionAs economies began to recover in the aftermath of the pandemic, consumer spending in the U.Sand Europe rebounded rapidly, buoyed by nearly a doubling of stock market values since the onset of the pandemic

This robust wealth effect sparked surging consumer demandWhen individuals possess heightened inflation expectations, they tend to expedite purchases, thereby further propelling inflation through pre-emptive demand.

Secondly, supply chain disruptions have led to shortages and increased costs, diminishing overall supply capabilitiesEvents such as extreme weather conditions increasingly impacted global agricultural productivity, affecting at least one-third of crop yieldsFurthermore, labor advantages in key raw material producing countries were eroded due to pandemic pressures, leading to escalating labor costsEnvironmental regulations imposed by various governments increased the cost of producing raw materials, compounding supply challengesLastly, traditional energy producers have shown a lack of enthusiasm in expanding production capacity amidst the transition to renewable energy—a process that typically requires two to five years to materialize and, at this juncture, can scarcely address current issues.

Thirdly, an environment of excessive monetary easing has resulted in rampant market liquidity, inflating commodity prices

The Quantitative Easing policies enacted by central banks in the U.Sand Europe since 2020 led to unprecedented monetary expansionBy June 17, 2022, the Federal Reserve and the European Central Bank's balance sheets had exploded by $4.76 trillion and €4.16 trillion (approximately $4.28 trillion) respectively, compared to pre-pandemic levels in early 2020. This overproduction of money fueled a rapid influx of cash into international commodity markets, resulting in soaring pricesBy June 2022, Brent crude oil futures averaged an 86% increase since January 2020, while the CRB Index—a benchmark for global commodity prices—surged by 78%.

Currently, the monetary tightening efforts by central banks in the U.Sand Europe appear to primarily dampen demandEven so, their actions remain sluggish regarding the withdrawal of Quantitative Easing policies

The Federal Reserve only commenced its asset reduction in June 2022. Meanwhile, while the European Central Bank concluded its emergency bond-buying program (PEPP) in March 2022, the regular asset purchase program (APP) is still ongoingSuch tightening measures show little immediate promise in alleviating supply-side issuesUnfortunately, this suggests that the underlying issues driving current inflation may persist for a while longer, with global economies at risk of entering a prolonged stagflation period characterized by low growth, high inflation, and high-interest rates amidst rising market volatility.

Looking ahead, the trajectory of the Federal Reserve's monetary tightening reflects lessons from the experiences of the 1980s in combating inflationThe current strategy appears to allow for temporary tolerance of economic recession in the face of soaring inflation, only shifting focus to economic support as inflation begins to trend downwards.

Should the CPI in the U.S

continue to rise and breach new highs, the Federal Reserve may boost the pace of rate hikes, potentially raising the single hike amount from 75 basis points to 100 basis points—or even higherAs of Q1 2022, the GDP growth rate was recorded at 3.5%, and a positive growth rate may well persist into Q2. As long as the GDP growth remains in positive territory and inflation has not subsided to the 2% goal, aggressive hiking may be critical for effective inflation controlIf June's CPI data does not set a new high, the likelihood for a 75-basis point hike in July is considerable; otherwise, a 100-basis point hike could be on the horizonThere are expectations for a 75-basis point increase in September, far exceeding the current market's 50-basis point estimatesShould the GDP shift into negative growth before inflation shows a definitive downward trend, the Federal Reserve might continue upping rates, albeit with reduced increment sizes; once a trend decline is identifiable in inflation, considerations for rate cuts may arise as a means to stimulate economic activity.

Concerning balance sheet reductions, if the pace continues as planned at a monthly decrement of $47.5 billion, escalating to a ceiling of $95 billion after three months, the current balance sheet—which stands at $8.98 trillion—would need approximately 16 to 17 months to shrink to roughly $7.54 trillion, a 16% reduction

Even with such cuts, the balance sheet would still represent a considerable 79% increase over pre-pandemic levels from January 2020. Such an aggressive reduction in the balance sheet may not yield substantial outcomes in terms of curtailing inflation through monetary policyIt would be unwise to rule out the potential for faster reductions should inflation reach new heights.

Recent research from the San Francisco Fed indicates that only about a third of the current high inflation in the U.Sis demand-drivenWhile rigorous monetary tightening can address demand-pull inflation, the capital expenditure costs associated with new commodities investment have soared, diminishing the supply incentives significantlyGiven the pervasive blend of demand, supply, and monetary forces driving this round of inflation, it remains plausible that even if the Federal Reserve sacrifices economic growth and employment rates, it may still be a long while before inflation returns to the 2% target.