The big pitfall for the Fed

By Mohamed A. El-Erian

Over the past 18 months or so, the quick and easy interpretation of inflation data has been proven wrong. Will things be different in the future? The markets certainly hope so. Federal Reserve officials seem more cautious — and rightly so. The markets’ latest change of narrative is not the best for the world’s most powerful central bank.

When the threat of inflation first reared its ugly head early last year, the Fed, most market participants and analysts immediately found reasons to downgrade it.

The drivers of rising inflation were external, small in number and historically predisposed to be quickly reversible. The choice of “transient” as a label for inflation was quick and easy, especially since it required no change in approach. After all, you just “watch” passing phenomena pass in front of you.

As inflation continued its path and its rise accelerated, markets moved away from the view of its transitory nature, but the Fed held on to it until late November. But already by then inflation had begun to become deeply embedded in the economic system and the driving factors behind its rise were expanding.

Delusions

With the Fed finally raising interest rates and charting a path for quantitative tightening by shrinking its balance sheet, both policymakers and many analysts and market participants initially believed in a “soft landing” effect—that is, the possibility of a reduction in inflation without much damage to growth. Again, it was the quick and easy view. Again, this proved biased and oversimplified.

It didn’t take long for markets to start pricing in a significant recession risk due to the realization that, with the Fed so far behind on inflation, its need to raise rates quickly and aggressively would likely hurt economic activity significantly. . Both stocks and bonds began to sell off sharply and the yield curve began to invert.

It was time for the Fed’s reassuring words about a soft landing to give way to a more cautious tone, along with a more decisive policy narrative that would include an “unconditional” commitment to fight inflation. The yield curve inversion deepened, at one point approaching minus 50 basis points for the spread between the 2-year and 10-year US Treasuries. The Fed said it intended to avoid giving guidance on its future moves after its series of setbacks and awkward turns.

The recent combination of a stronger-than-expected US jobs report and better-than-expected inflation data has brought back the dominant narrative in the markets – once again the quick and easy fix. The decidedly much more upbeat economic tone is based on the view that the Fed will be able to complete its tightening cycle in the coming months and even begin to “relax” as early as next year, limiting the blow to growth, employment and incomes.

The above puts the Fed in a difficult position. Should he go with the flow and validate with deeds and words the easing of financial conditions that the markets are discounting? Or will it remain flat and risk upsetting markets that have regained their footing after a damaging first half of 2022?

The hard road

Tempting as it may be to take the easy course again, the Fed should resist yet another approach that risks keeping the threat of inflation alive for much longer.

This would not only result in further erosion of purchasing power, but would also further damage growth prospects and place an even greater burden on the most vulnerable sections of our society.

The Fed must remain steadfast on its course and do everything it can to put the inflation genie back in the bottle. This is not easy and is far from safe. However, it is indisputably better than the other policy alternative available to a Fed that, because of its past mistakes, no longer has good external credentials.