Under the pressure of stagflation, the Fed's dual target system determines that it pays more attention to employment than economic growth in terms of "stagflation".

The Fed implements a dual target system, anchoring price stability and full employment, and economic growth is not among them; under the pressure of stagflation, the Fed dual target system determines that it pays more attention to employment than economic growth in terms of "lag". In general, high unemployment rate often coexists with low growth, but the rise of unemployment rate has a certain lag, in other words, the layoff behavior of enterprises will lag behind the economic inflection point for about one year, which is also applicable at present.

We expect the US economy to decline quarter by quarter this year, and Q2 will show a downward inflection point throughout the year, but because of the time lag effect of the recession and the rising unemployment rate, the unemployment rate is expected to bottom out in the second half of the year. Considering that the Fed anchors high inflation and high unemployment in the stagflation environment, and under the background of the current good job market, the weakening of the Q2 economy will not be a constraint on the Fed's interest rate increase and contraction table; however, it is necessary to continue to observe the changes in the unemployment rate from the second half of the year, which may gradually bottom up and focus on the policy response of the White House and the Federal Reserve to the rebound in unemployment rate.

The Fed controls inflation expectations rather than inflation, so the Fed is more concerned about breaking inflation expectations.

In the late 1970s, Federal Reserve Chairman Volcker adopted very strong tightening measures to deal with inflation expectations, in addition to price-based regulation (raising interest rates and raising the discount rate), but also increased quantitative control targets (setting growth targets for the money supply). Although Friedman's theory of the quantity of money prevailed at that time. But Volcker stressed that he did not adopt the quantity theory of money but adopted the school of rational expectation. The Fed must exceed market expectations in order to curb inflation expectations.

Exceeding expectations is shown in two aspects: policy tools and strength. In policy tools, in addition to the discount rate, Volcker also sets the growth target of money supply, in addition to cooperating with the Carter administration to control consumer credit. In terms of policy strength, in order to deal with the great stagflation, Volcker believes that controlling inflation is to a large extent a psychological war, the core of which is to reverse the market's expectation that prices will continue to rise. establish the credibility of the central bank's determination to control and combat inflation. To this end, we should maintain the continuity of monetary policy and do not hesitate to ignore the increase in unemployment and political pressure before the fall of inflation expectations until there is a significant fall in inflation expectations.

For the current round of high inflation in the United States, Powell is more likely to learn from Volcker to adopt a more-than-expected tightening approach to curb inflation. These include higher-than-expected interest rate increases (rapid return to above neutral interest rates), stronger-than-expected contraction (there is still room for linear enhancement of about $40 billion in the upper limit of the speed of the contraction), and longer time window (the duration of the contraction is longer than that of interest rate increases).

The extent of the Fed's short-term interest rate hike and the time dimension of the contraction table may exceed market expectations.

Considering the demand for progressive tightening and the return of the federal funds target rate to above the neutral rate, we believe that the potential path for the Fed's follow-up policy is to raise interest rates 50BP in May and 75BP in June-July. According to this path, the upper limit of the federal funds target rate in July will reach 2.5% and exceed the neutral rate. Since then, the process of raising interest rates will gradually weaken or even not raise interest rates, mainly because the vote in the mid-term elections (November) after August may disturb the rate increase. In terms of shrinking tables, the speed of shrinking tables in May, June and July will gradually increase to $95 billion and will continue at a uniform speed until the end of the year. (in addition, we do not rule out the possibility that the shrinking table is stronger than expected. The current national debt shrinking table is still nearly $40 billion short of the theoretical limit. The above rhythm will help the Fed achieve multiple goals).

In terms of raising interest rates, first, the gradual tightening of Q2 will help inflation expectations fall as soon as possible, increasing and advancing the existing interest rate raising plans, which has a better suppressing effect on inflation expectations than a uniform "blunt knife" interest rate increase. Second, this rhythm can enable the Federal Reserve to quickly raise the policy interest rate to and above the neutral interest rate in July, thus leaving time space for the subsequent adjustment of the monetary policy position, especially before the election. Judging from the decision-making experience during Powell's tenure, the administrative intention of the White House has often become an important intervention factor for the Federal Reserve. Against the backdrop of downward inflationary pressures and rising unemployment in the second half of the year, the Biden administration may have a broad monetary demand under the pressure of winning the election.

In terms of contraction, first, it can delay the risk of interest rate reversal at the long and short ends of US debt, and second, it can reduce the money supply and depress demand and inflation. it should be pointed out that the contraction table is only used as an auxiliary means of raising interest rates in controlling inflation and suppressing demand, and the main means for the Fed to adjust its policy stance is still to raise interest rates (as clearly stated in the principles of monetary normalization issued this year).

Us bond yields and the dollar are still likely to rise before July, and opportunities for US stocks will have to wait until the table of interest rate hikes and shrinks becomes clear.

In terms of US debt, it is likely to rise further to 3.5% in July. Before the Fed's policy adjustment touches neutral interest rates in July, it is likely to take a policy stance that continues to exceed expectations in order to dampen inflation expectations. 10-year Treasury yields, driven by tightening expectations, could rise as high as 3.5% during the parallel period of the rate hike and contraction table in July. real interest rates may further break through 0.5% to 1% (real interest rates topped 1% during the parallel period of 2018), and inflation expectations may gradually fall back towards the 2% desired direction of the Fed.

As for the dollar index, it is expected to rise further to around 105, driven by continued tightening than expected.

There is still room for US stocks to decline in the short term, but the risk of collapse is manageable, and the opportunity for US stocks will have to wait until the table of interest rate hikes and contraction is clear. Us stocks still face downside risks in the face of strong expectations of interest rate hikes and contraction. In the case that the Fed tries to control the US bond yield curve not continuously upside down, and the early risk of US stocks has been released to a certain extent, the risk of collapse can be controlled.

Risk hint

Due to excessive concerns about corporate profits in US stocks, US stocks collapsed, creating systemic risk concerns and triggering a sovereign debt crisis; a faster-than-expected downturn in the Chinese economy could lead to a change in the Fed's interest rate increase and contraction schedule.