Judging by the US Federal Reserve’s body language, US monetary officials finally seem hell-bent on combating the nation’s raging inflation problem . The Fed is making all the right noises about inflation risks running too high and the jobs market operating close to full employment while emphasising the need to scale back the exceptional monetary super-stimulus which has saturated the US economy since the 2008 crash. Years of near zero interest rates and the Fed’s quantitative easing programme, which has exploded the central bank’s balance sheet close to US$9 trillion, have made great progress. The measures have staved off deeper disaster from the 2008 crash and supported the economy while the Covid-19 pandemic raged. But with headline consumer price inflation running at 7.9 per cent and due to go higher in the coming months, super-stimulus has overstayed its welcome. Hints of impending half-point interest rate hikes seem to have impressed so far but is the Fed leaving the job half-finished and the markets short-changed? When the US yield curve begins to invert and short-term interest rates exceed long-term bond yields, it’s generally read as an early warning sign the US economy may be heading into recession . The great debate in the market right now is whether the Fed is ready to squeeze down so hard on inflation that it is prepared to tip the economy back into hard times. It seems to be what the spread between the two- and 10-year Treasury bond yields is hinting at, having dipped back into negative territory in recent trading sessions. Since the 1970s, inversion of the 10-year less two-year Treasury spread has strongly correlated with foreshadowing the US economy falling into recession by anywhere between six months and two years further ahead. Should we be worried the Fed is about to risk a new recession with a tougher policy onslaught? It really depends which part of the US yield-curve you look at. While the 10-minus-two-year Treasury spread seems to be an early precursor to possible recession, the front end of the US curve seems to carry a different message – that the Fed is still holding back and lagging behind what’s needed to tame inflation. The spread between the key Fed funds rate and 10-year Treasury yields has sprung the opposite way with the yield gap rising over 2 per cent while the 10-minus-two-year Treasury spread has sunk back to zero. This reflects how rising inflation expectations have hit US bond yields, while the Fed, up until recently, has dragged its feet over tightening policy. Strong hints about the need for higher half percentage point rises may be one thing, but the bond market bears want action rather than words. The Fed needs to revise up its expectations about how much higher US rates need to go before inflation risks are squashed. The central bank’s official projections are still only assuming a median target for Fed funds of 2.8 per cent by 2024. Given where inflation currently is right now and where it could be heading in the worst case scenario, more could be done. The Fed funds rate could easily double that level in the next two years to contain future inflation risks. With global energy prices surging , domestic wage pressures pushing higher and the University of Michigan inflation expectations series running at a 40-year high, it’s no wonder US bond yields are starting to panic. Ten-year Treasury yields at 2.7 per cent are already back above pre-pandemic levels and could quickly return to pre-2008 crash levels above 5 per cent if the Fed fails to respond in time. So what’s holding the Fed back? The Fed seems stuck between a rock and a hard place, worried that pushing too hard on inflation might spark recession, while being easy on growth could let inflation spin out of control. It’s the fallout from the pandemic and the war in Ukraine which is doing the damage and preventing the Fed from bearing down too hard on inflation for the time being. Gradualism rather than shock tactics looks likely to prevail. The Fed can’t afford to kick the inflation can down the road much longer. The longer the Fed waits, the harder it will be to regain price stability around 2 per cent. The bond market hawks will be without mercy. David Brown is the chief executive of New View Economics