The Fed has failed on four counts

Of Mohamed A. El-Erian

Global economic watchers and market participants will pay close attention next week to how the U.S. Federal Reserve describes the country’s economic outlook, the size of its rate hike and whether it changes the pace of its balance sheet shrinkage. .

But for the well-being of the U.S. and global economy, the answer to these questions is less important than whether the Fed is serious about correcting four failures that continue to fuel one of the worst policy mistakes in decades: failures of analysis; forecasting, response and communication.

Let’s first deal with what economists and markets seem to be most interested in right now.

Turning to the economic outlook, the Fed will acknowledge that once again, inflation has proved higher and more persistent than forecast and that despite some signs of weakness, the US economy remains in a “good place”.

With that, it is likely to raise interest rates again by 75 basis points and leave previously announced plans for quantitative tightening unchanged.

That will come as a relief to those who worry that the Fed, playing a desperate game of catch-up, will raise interest rates by 100 basis points and exacerbate the already uncomfortably high risk of tipping the US economy into recession.

However, such easing will once again prove without substance unless the Fed also regains policy credibility by addressing its four persistent failures.

The first is that of analysis. The Fed has yet to make the overall analytical shift from a world dominated for years by deficient aggregate demand to one where deficient aggregate supply plays an important role.

Its approach to monetary policy is either still formally governed by the “new framework” adopted last year which is no longer appropriate and should be publicly rejected, or is governed by no framework at all, leaving the US and global economy without a much needed base.

The result of this is a central bank constantly trying to properly inform and influence economic agents, consistently lagging behind the markets rather than leading, and that could easily fall victim to the even more disastrous mistake of returning to the trap of the decade 1970 with “stop-go” policies.

For an illustration of the Fed’s inadequate policy, consider the market’s recent prediction of what it will announce on Wednesday. In just a few days, the probability that the Fed would raise interest rates by 100 basis points, an unusual amount, went from insignificant to normal, then back to unlikely.

The longer the US central bank resists a belated shift to analysis, the more its inflation and growth forecasts will continue to miss the mark, exacerbating the second failure.

In recent quarters, such forecasts have been quickly and correctly dismissed as unrealistic by a wide range of economists, market analysts and former Fed officials. This is even more important now that the US economy is showing signs of not just weakening, but flirting with recession.

Third, the Fed needs to be more flexible in its policy responses. It is now widely accepted that after clinging to the misguided inflation argument for too long, he should have responded more forcefully when he finally retracted that mischaracterization.

This was confirmed by former vice chairman Randal Quarles last week, who also addressed the concern that I and many others have that the Fed has become “one” with the markets.

Finally, the Fed needs to be more straightforward in its communication. it appears to remain the central bank in advanced economies most prone to “fairy tale economics”, as former British Chancellor of the Exchequer Rishi Sunal pointed out. And it is the most systemically important of all these central banks.

Regardless of what the Fed does next week, if it doesn’t address these four problems, the central bank will continue to lack the credibility needed to be remembered by economic historians as the one that needlessly caused the U.S. recession. having destabilized a global economy still struggling to recover from the coronavirus, having exacerbated inequality, fueled economic instability and contributed to pressures on the bonds of fragile developing countries.