A big risk off week has seen government bond yields rise and share markets fall. The frothiest assets, US tech companies and crypto currencies, saw the biggest falls. The main reason for the sharp falls in financial asset prices last week was further undermining of the rapid economic growth, benign inflation, low interest rate paradigm that previously fostered high valuation of high-risk assets in particular.

This week, the US Federal Reserve’s monetary policy meeting over Tuesday and Wednesday is a key event for global financial markets. Fed guidance through the speeches and comments of senior officials has turned sharply over recent weeks. The Fed was promising to move slowly in the face of inflation that through 2021 proved to be less temporary and higher than expected. That has changed quite abruptly to the need to move more quickly and repeatedly.

Over recent weeks the Fed has moved from promising to slowly wind back purchases of bonds to quickly ending bond purchases and becoming a net seller of bonds. Concerning the Federal Funds rate set currently at 0-0.25% the Fed has changed guidance from no change before 2023 to at least three rate hikes in 2022 and possibly bigger than customary 25bps rate hikes to move more quickly to deal with inflation that the Fed admits is unacceptably high.

Fed action so far has been limited to reducing the size of regular bond purchases but the guidance concerning what it may do has changed sharply in a very short period from cautious removal of monetary support to promising much more aggressive removal of support. If the Fed matches its recent guidance at the FOMC meeting this week and ends QE and hikes the funds rate 25 or 50bps that may prove paradoxically positive for financial markets, although only temporarily and shakily positive “selling the rumour and buying the fact”.

Almost certainly, the Fed will indicate in the statement accompanying the monetary policy decision that there will be a series of rate hikes ahead. Indications of how quickly those rate hikes will occur may determine whether the current setback in risk asset prices and rise in bond yields is interspersed with significant recovery phases.

It is worth keeping in mind that the real US economy is still in good shape and able to contend with higher borrowing costs. Household wealth is high and debt comparatively low. Wages are rising 5% y-o-y. Businesses are mostly thriving responding to strong growth in US internal demand. The 10-year US bond yield is still only around 1.70% in an economy with inflation at 7.0% y-o-y. Even if the Fed hikes the funds rate quickly to 1.00% and above, that is still very low in real terms.

Nevertheless, if the Fed hikes aggressively this week and promises regular, quick hikes beyond, US financial markets until recently priced for high growth perfection will struggle to recover.

In Australia, what the Fed does this week will matter influencing overseas borrowing costs as well as prospects for global economic growth and international trade. The local Q4 CPI release on Tuesday may matter as well.

The RBA continues to run the case that inflation pressures in Australia are lower and different to those being experienced in Europe and the US. While supply chain pressures are pushing up prices in Australia those pressures will eventually fade and are unlikely to be reinforced by unduly strong wage growth. Annual wage has been and will continue to be slow to rise according to the RBA. As a result, the RBA can afford to be patient before lifting the cash rate. It can wait until actual inflation is at or above the high end of 2-3% target range consistently.

Throughout 2021 the RBA has revised its in-house inflation forecasts higher. Going back a year to the February 2021 Monetary Policy Statement, the RBA forecast that December 2021 inflation (the Q4 inflation report this week) would be 1.5% y-o-y for the CPI and 1.25% for the underlying (trimmed mean) inflation rate. Successive quarterly upward revisions saw the November 2021 Monetary Policy Statement forecast December 2021 inflation at 3.25% for the CPI and 2.25% for underlying inflation.

Consensus market forecasts for Q4 inflation out on Tuesday are 1.0% q-o-q, 3.2% y-o-y for the CPI and 0.7% q-o-q, 2.4% y-o-y for underlying inflation. The CPI consensus forecast is in line with the RBA’s November forecast, but the underlying inflation forecast is above at 2.4% y-o-y and is within spitting distance of moving above 2.5%, the mid-point of the RBA’s 2-3% target range.

Although the RBA is targeting the headline CPI it can live with the CPI pushing above target (as it is currently) if there is a case for the CPI to slip back inside range. The CPI is often subject to one-time special influences that dissipate or reverse. Underlying inflation measures try to limit or eliminate the influence of one-time influences and present a truer measure of where the headline CPI will travel over time.

If the Q4 inflation readings come in as the market expects at 3.2% y-o-y for the CPI with an underlying annual inflation reading coming in at 2.4% y-o-y there remains the possibility of the CPI settling back to around 2.4% y-o-y later this year. The problem is that 2.4% y-o-y underlying inflation will soon lift to 2.8% or higher. Both the Q3 2021 and expected Q4 quarterly underlying inflation readings each at 0.7% q-o-q annualise at 2.8%. Also, there is no room for upside surprise in the Q4 reading as a 0.8% q-o-q result annualises at 3.2% indicating little hope of the headline annual CPI going below 3% y-o-y any time this year.

The Q4 CPI and underlying inflation report on Tuesday is a key one for the RBA indicating whether they must revise their inflation forecasts higher again in the early February Monetary Policy Statement. Any upward revision of their November forecasts will show inflation travelling at the high end of target range throughout 2022 and 2023, a very hard environment to stay “patient” before hiking the cash rate.

The RBA does not face an urgent need to hike the cash rate like the US Fed, but it is unlikely to last much more than 6 months before local inflation readings push the need to hike.  The changing US and local interest rate outlook present challenging times for risk assets and events and data reports this week may give a guide to how great the challenges will be.