Inflation has surged over the past couple of years and that has triggered a significant correction in the stance of monetary policy. Central banks raised their policy rates by multiple percentage points and in some cases started the process of unwinding the massive expansion in their balance sheets that had taken place over the previous decade.
Inflation may still be high today but current market pricing suggests that this global hiking cycle is almost complete, with only a handful of 25 basis points hikes still to be delivered in most jurisdictions over the next few meetings before rates reach their terminal level for this cycle.
Whether those market expectations will be validated or not will depend on how the economy behaves and in particular whether inflationary pressures soon start to abate. This note does not discuss whether that is likely or not, but instead asks what might happen after that: where is the economy and the stance of monetary policy likely to go after rates have unambiguously reached terminal?
The answer to this question lies in understanding the strategy that central banks are currently pursuing to tame inflation. Yes, interest rates are high because inflation is high. But the link between them is not mechanical. As the narrative on inflation has changed – why inflation is high and whether inflation is likely to stay high – then so has monetary strategy, so we start there.
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