US monetary policy is set to tighten with inflation now at a level not seen since the 1980s. And Federal Reserve actions will affect Hongkongers, given the Hong Kong dollar’s peg to the US dollar via the Linked Exchange Rate System. But real-world considerations may limit how far Fed tightening can go. That might suit Hong Kong, where consumer price inflation is currently well below that of the US. A 0.25 percentage point rise in US interest rates may well now occur in March, with further incremental hikes to follow, but this certainly won’t be a rerun of then Fed chair Paul Volcker’s 1980s all-out campaign against rising prices – even if, as the Fed’s Lael Brainard said last week, controlling US inflation is now the central bank’s “most important task”. Brainard’s comments came after data revealed that the headline US consumer price index hit 7 per cent year on year in December, the highest since June 1982. In contrast, overall CPI in Hong Kong increased by an annualised 1.8 per cent in November, according to the latest figures from the Census and Statistics Department. Fed policymakers, who only recently held that US inflation pressures were “transitory”, are now flagging the need for multiple interest rate hikes this year and are being transformed from monetary policy doves into sharp-taloned hawks. Some might argue that the Fed has been slow in rediscovering its hawkish tendencies, with headline US CPI now more than triple the 2 per cent level the central bank ordinarily targets, even if the Fed would point out that it has had a pandemic to contend with. Either way, it is probably best not to get too carried away with how far the Fed might go. In the decades since Volcker stepped down as Fed chair in 1987, the understandable response of the central bank to periodic non-inflation-related economic and financial crises has ultimately been to embrace ultra-accommodative monetary policy settings, where rock-bottom US interest rates and quantitative easing have helped generate debt-financed recoveries. But such policy responses come with consequences. Supercharged money printing generally feeds into high financial market valuations, and optimistically priced markets can often prove vulnerable to severe sell-offs if monetary policy is subsequently tightened too far. Of course, no one should expect the Fed, or any central bank, to admit that their willingness to keep tightening monetary policy, when confronted by rising inflation, is partly constrained by a desire to avoid triggering financial market turmoil, but that doesn’t stop financial markets believing that is the case. The Fed is clearly laying the ground for higher US interest rates, but it can only go so far, and the markets know it. On December 15, well before the current US CPI data was published, the Federal Reserve’s Summary of Economic Projections was envisaging a “longer run” median level of 2.5 per cent for the benchmark Fed Funds rate. Yet, as John Velis, foreign exchange and macro strategist for the Americas at US bank BNY Mellon, pointed out, even after the release of that eye-catching US inflation data, “the equilibrium policy rate inferred from [Overnight Index Swap] futures is much lower, just around 1.8 per cent, some 70 basis points below the Fed’s estimate”. It would appear the markets are not buying what the Fed’s December projections summary was trying to sell. What to expect in a year of policy tightening and US interest rate rises Indeed, in a colourful nod towards the Fed’s sensitivity to risks around tighter monetary policy, leading to financial market turmoil, Albert Edwards, global strategist at French bank Societe Generale, argued that even though the US central bank projects “the ‘neutral’ Fed funds at around 2.5 per cent, they’ll struggle to get rates above 1.5 per cent before the financial markets chop them off at the knees”. Additionally, while the Fed is an independent central bank, it does not exist in a political vacuum. The Biden administration has also been expressing concern over US inflation, but the White House will be well aware that every Fed rate hike also raises the cost of servicing Uncle Sam’s mountainous debt pile. With its own CPI at 1.8 per cent, way below the US inflation level, Hong Kong doesn’t necessarily need monetary policy as tight as the US does. But the linked exchange system means that US interest rate hikes get passed on to Hong Kong regardless. It might just suit Hong Kong, on this occasion, if the Fed does find there are real-world limitations on the scope for US monetary policy tightening. Neal Kimberley is a commentator on macroeconomics and financial markets