The persistent failure to do so over the past 12 months transforms the Fed’s perception of the world’s most powerful central bank – long respected for its ability to anchor global financial stability – into one that looks too much like a bank. emerging market that lacks credibility and inadvertently contributes to excessive financial volatility. Regaining control of the inflation narrative is critical to the Fed’s policy effectiveness, reputation, and political independence. The longer it takes, the greater the negative effects on economic well-being and social equity in the United States, and the greater the negative fallout for the rest of the world.
Evidence of the Fed’s loss of control has grown uncomfortably in recent weeks.
Once again, its inflation forecasts, one of its dual mandates, have been wrong. Meanwhile, longer-term inflation expectations have deviated further from the Fed’s 2% target, with the University of Michigan’s measure for the next five to 10 years hitting a multi-decade high of 3.3% . With that, even the part of the market where the Fed has the most influence, characterized by the yield of two-year Treasury bills, has seen large and disorderly bull movements that scare one of the most critical segments. global financial markets.
Equally worrisome is the Fed’s misinterpreted attempt at clarification. Its announcement of two 50 basis point hikes a few weeks ago initially led the markets to consider a pause in the rate cycle in September. This thinking was then firmly replaced by speculation of an immediate 75 basis point hike on a trip to a terminal rate well above anything mentioned by the Fed.
This caused even more excessive volatility in the markets; and with that comes a greater distance for the Fed from the “first best” policy response and a deepening of a lose-lose policy dilemma that is largely of its own creation – that is i.e. tighten the political brakes to fight inflation at the cost of a consequential risk of recession or to brake more gently and risk persistently high inflation through 2023.
The idea of a central bank constantly chasing inflationary developments, running out of good policy options and, in doing so, intensifying economic and financial volatility would not be uncommon in a developing country lacking institutional credibility and maturity. This is very unusual, and particularly distressing, for the central bank which is at the center of the international monetary system.
This results in an amplification of negative spillovers for the rest of the world, jeopardizing the financial stability of some of the countries on the periphery of the global system. In the country, it undermines economic prosperity and adds to the considerable pressures already facing the most vulnerable segments of the population.
Fortunately, the urgency to regain control clarifies the immediate actions the Fed must take.
First, he must share his analysis of why he repeatedly misread inflation for so long and how he has now improved his forecasting abilities. Without this, the Fed will continue to struggle to convince the markets that it has inflation under control, which will lead to a further unanchoring of inflationary expectations.
Second, the Fed needs to show that it is serious about fighting inflation, not just in words but in actions. Having handled the build-up to this week’s Federal Open Market Committee meeting so badly, he has no choice but to raise the federal funds rate target by 75 basis points, undermining his own policy stance at term of 50 basis points announced last month. and do something that Fed Chairman Jerome Powell had ruled out.
Third, by increasing 75 basis points, he must also credibly convey the idea that this is part of a journey, and he must avoid repeating the spurious error of precision – a direct error he made at a few times over the past few months. .
Although operating in a more difficult environment due to the weak regional economy and the risk of “widespread fragmentation”, the European Central Bank has recently taken important steps in this regard. The longer the Fed delays doing the same, the more markets will revise inflation expectations upwards as well as the magnitude and speed of the rate hike cycle. The result of this, should it materialize, will be that the current baseline of stagflation in the US will give way to recession; and, once again, as economic insecurity increases due to both higher prices and more uncertain income prospects, the most vulnerable segments of the population will be hardest hit.
I warned a year ago that by insisting that inflation was ‘transitory’, the Fed risked one of its biggest policy mistakes whose consequences would be felt beyond the economy. American. Since then, it’s like watching a bad dream unfold in stages. Hopefully, the Fed will use this week’s FOMC meeting to exit the problematic policy regime it has placed itself in, avoiding even more undue damage to economic well-being, prospects, and social equity.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and President of Gramercy Fund Management. He is the author of “The Only Game in Town”.
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