Editor’s note: Mohamed A. El-Erian is President of Queens’ College, University of Cambridge, Renee Kerns Professor at the Wharton Business School, Senior Fellow at the Lauder Institute, and Advisor to Allianz and Gramercy. He sits on the boards of Barclays, NBER and Under Armour. The opinions expressed in this commentary are his own.
This week, it will become more apparent to economists and policymakers around the world that the Federal Reserve is in a catch-22 situation of its own making. Forced by worries about persistently high inflation, the Fed will likely go down in history as having raised interest rates by the same amount in three consecutive policy meetings. But because he does so in a weakening economy, he will be criticized for harming not only national economic well-being, but also global growth.
This unfortunate situation the Fed finds itself in—too bad if you do, and too bad if you don’t—illustrates a deeper problem. Having missed the window where a “soft landing” for the economy was possible (i.e. a drop in inflation without too much damage to the economy), the Fed now finds itself desperately out of the world of “first-order” policy-making. In other words, rather than having highly effective, timely and well-targeted inflation-fighting measures at its disposal, this Fed has found itself in a world in which virtually all of its policy actions can cause damage. significant collateral and unintended negative consequences. Many politicians, businesses and households are likely to think the Fed is part of the problem, not part of the solution.
What is expected to be a record third consecutive 75 basis point rise comes amid damaging increases in the cost of living that have gained momentum and, making matters worse, have become more structurally embedded economy. Headline inflation, currently at 8.3%, may be down, but the base rate, which excludes more volatile categories like food and gasoline, continues to rise. And it is the latter, currently at 6.3%, which measures the magnitude and likely persistence of inflation.
Yet, for most of last year, the Fed consistently downplayed the inflationary threat. Meanwhile, the economy continued to be conditioned to operate with zero interest rates; and markets continued to be reassured by the Fed’s repeated interventions to offset falling stock prices (the so-called “Fed Put”).
But it wasn’t until late November last year that the Fed repeatedly stopped assuring us that inflation was “transitional”. Just a few months ago, it was still injecting cash into the economy as inflation rose rapidly.
Now the Fed realizes that it was very late in reacting. By allowing inflation to become more entrenched – or, as Chairman Jerome Powell put it last month, “to spread through the economy” – the Fed must now be much more aggressive than it was before. should have been had she reacted in time. The Fed must also avoid another blow to its already damaged reputation and political credibility.
Rather than lead the markets in the fight against inflation, the Fed was forced to follow them. Until Powell’s hawkish pivot last month at the Jackson Hole economic symposium, he had repeatedly been forced to revise his policy guidance to make it more consistent with what markets had signaled. Added to seemingly endless one-way revisions to major economic forecasts (higher inflation and weaker growth), this has unfortunately changed the economic and financial role of the Fed from confidence leader to laggard.
Yet, because it was so late to react, the Fed will aggressively engage in a weakening domestic and global economy. Thus, a growing number of economists are warning that the Fed will tip the United States into recession; and a growing number of foreign policymakers complaining that the world’s most powerful and important central bank is pulling the rug out from under an already fragile global economy. That’s a far cry from the Fed’s much-celebrated role in helping stave off the hugely damaging global depressions of 2008-09 and, more recently, 2020.
This week’s political action could well end up in three different parts of our economy’s history books: the first time the Fed has raised rates by 75 basis points in three consecutive meetings; another element of the central bank’s biggest policy mistake in many decades; and an unusual example of a developed country’s central bank finding itself in a political hole that is more familiar to peer institutions in some developing countries.
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