The US Fed must go beyond a mere 75 basis points rate hike
Premium- The central bank should do its best to regain credibility on inflation
While market chatter in the run-up to Wednesday’s Federal Reserve interest rate decision focused on whether the increase will be 50 or 75 basis points, and 75 it eventually was, the critical issue in play is broader. For its sake and that of both the US and global economy, the Fed must regain control of the inflation narrative. Its failure to do so in the past 12 months is turning the perception of the Fed from the world’s most powerful central bank, long respected for its ability to anchor global financial stability, to an institution that too closely resembles an emerging-market bank that lacks credibility and inadvertently contributes to undue volatility. Regaining control is critical to the Fed’s policy effectiveness, its reputation and its political independence. The longer this takes, the worse it is for everyone.
The evidence of the Fed’s loss of control has multiplied. Once again, its forecasts for inflation, one of its dual mandates, have been off. Meanwhile, longer-term inflationary expectations have deviated further from the Fed’s 2% target, with the University of Michigan’s measure for the next 5-10 years reaching a multidecade high of 3.3%. With that, even the part of the market on which the Fed has the most influence, typified by the two-year Treasury note yield, has been subject to eye-popping large and disorderly moves up that are frightening for a critical part of global financial markets.
Just as worrisome is the Fed’s misplayed attempt at precision. Its signalling of two 50-basis-point increases a few weeks ago first led markets to expect a September pause in the rate-hike cycle. That thinking was then firmly displaced by speculation about an immediate 75-basis-point increase on a journey to a terminal rate well above anything mentioned by the Fed. That caused yet more undue volatility in markets; and with that comes greater distancing 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, slam the brakes to fight inflation at the cost of a consequential risk of recession or tap the brakes more gently and risk persistently high inflation well into 2023.
The notion of a central bank chasing inflation, short of good policy options and, in the process, intensifying economic and financial volatility would not be uncommon in a developing country. It is highly unusual, and particularly distressing, for the central bank that is at the centre of the international monetary system. The result is amplified adverse spillover effects for the rest of the world, putting at considerable risk financial stability in some countries at the periphery of the global system. In the US it hurts economic prosperity and adds to the pressures already being faced by the most vulnerable.
Fortunately, the urgency of regaining control clarifies what the Fed must do.
First, it needs to share its analysis of why it has repeatedly misread inflation for so long and how it has improved its forecasting capacity. Without this, it will continue to find it rather difficult to convince financial markets that it has a handle on inflation, leading to a further de-anchoring of inflationary expectations.
Second, the Fed needs to show that it is serious about tackling inflation, not just in words but in actions. Having so mishandled the run-up to this week’s Federal Open Market Committee meeting, a 75 basis points hike was the least it could have done, even though its forward policy guidance issued last month was 50 basis points.
Third, having raised its policy rate by 75 basis points on Wednesday, it must also credibly convey the notion that this is part of a journey, and it must avoid repeating the mistake of spurious precision—an unforced error that it has made a couple of times in the past few months.
Notwithstanding the fact that it operates in a more difficult context because of the weaker regional economy and the risk of “spread fragmentation", the European Central Bank has recently taken some important steps in this regard. The longer the Fed delays in doing the same, the more markets will revise upward inflation expectations and the scale and speed of the rate-increase cycle. The result of that, should it materialize, will be today’s US stagflation baseline giving way to recession; and, once again as economic insecurity increases because of both higher prices and more uncertain income prospects, the most vulnerable segments of the population will be hit hardest.
I had warned a year ago that in insisting that inflation was “transitory", the Fed was risking one of its biggest policy mistakes whose consequences would be felt beyond the US economy. Since then, it has been like watching a bad dream play out in stages. I hope that the Fed will finally break out of the problematic policy regime it has placed itself in, thereby avoiding yet more undue damage to economic well-being, prospects and social equity.
Mohamed A. El-Erian is former CEO of Pimco, president of Queens’ College, Cambridge, and author of ‘The Only Game in Town’.