While the market chatter in Wednesday’s Federal Reserve interest rate decision focused on whether the increase would be 50 or 75 basis points, and ultimately was 75, the critical issue at play is broader. For this and for both the US and the global economy, the Fed must gain control of the inflation narrative. Its failure to do so over the past 12 months is shifting perceptions 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 plays an important role in an emerging market economy. Very similar to K Bank. Contributes to reliability and unintentionally undue volatility. Gaining control is critical to the Fed’s policy effectiveness, its reputation, and its political independence. The longer it takes, the worse it is for everyone.
The evidence for the Fed’s loss of control has multiplied. Once again, its forecast for inflation, one of its dual mandates, is off. Meanwhile, long-term inflation expectations have deviated further from the Fed’s 2% target, with the University of Michigan’s measure reaching a multi-decade high of 3.3% for the next 5-10 years. With this, the part of the market on which the Fed has the most influence, represented by the two-year Treasury note yield, has been subject to massive and disorganized moves that are catastrophic to a significant portion of global financials. Market.
Just as worrying is the misrepresentation of the Fed’s accuracy. Signs of two 50-basis-point hikes a few weeks ago had previously given markets hope for a September halt in the rate-hike cycle. That thinking was strongly displaced by speculation about an immediate 75-basis-point hike on a terminal rate trip above anything the Fed mentioned. This created further undue volatility in the markets; And with it a greater distance from the ‘first-best’ policy response for the Fed and a deepening of the give-and-lose policy dilemma that is largely its own creation: that is, the brakes slam to fight inflation at the expense of the resultant recession. Risk or tap the brakes more slowly and risk continuing higher inflation in 2023.
The perception of a central bank chasing inflation, a lack of sound policy choices and, in the process, intensifying economic and financial instability would not be unusual in a developing country. This is highly unusual and particularly troubling for the central bank at the heart of the international monetary system. The result amplifies the adverse spillover effect for the rest of the world, which significantly jeopardizes financial stability in some countries at the periphery of the global system. In America it hurts economic prosperity and adds to the pressures already faced by the most vulnerable.
Fortunately, the urgency to regain control makes clear what the Fed must do.
First, he needs to share his analysis of why he has repeatedly misread inflation for so long and how he has improved his forecasting ability. Without it, it would be difficult to convince financial markets that it has control over inflation, which could further lower inflation expectations.
Second, the Fed needs to show that it is serious about tackling inflation, not just in words but in actions. After mishandling the run-up to this week’s Federal Open Market Committee meeting, the 75 basis point increase could have been minimal, even though the forward policy guidance issued last month was 50 basis points. .
Third, after raising its policy rate by 75 basis points on Wednesday, it must also credibly convey the notion that it is part of a journey, and should avoid repeating the mistake of spurious accuracy – an unforced error. which he has done for some time. Several times in the last few months.
Despite the fact that it operates in a more difficult context due to a weaker regional economy and the risk of “scattered fragmentation”, the European Central Bank has recently taken some important steps in this regard. The longer the Fed delays this, the more markets will revise upward inflation expectations and the scale and pace of the rate-hike cycle. The result, should it materialize, will be the baseline for today’s US recession giving way to a recession; And, once again increasing economic insecurity with both higher prices and more uncertain income prospects, the most vulnerable sections of the population will be hit hardest.
I warned a year ago that by calling inflation “temporary,” the Fed was risking one of its biggest policy mistakes, the consequences of which would be felt beyond the US economy. Since then, it’s like watching a nightmare play out. I hope the Fed will eventually move out of the problematic policy regime it has placed itself in, avoiding further undue damage to economic well-being, prospects and social equity.
Mohamed El-Erian is the former CEO of PIMCO, President of Queens College, Cambridge, and the author of The Only Game in Town.