Editor’s Note: Mohamed A. El-Erian is the president of Queens’ College at Cambridge University, the Renee Kerns Professor at the Wharton Business School, senior fellow of the Lauder Institute and advisor to Allianz and Gramercy. He serves on the boards of Barclays, the NBER and Under Armour. The opinions expressed in this commentary are his own.
This week, it will become more apparent to economists and policymakers across the globe that the Federal Reserve is in a Catch-22 situation of its own making. Forced by worries about high and persistent inflation, the Fed will likely go down in history as having raised interest rates by the same large amount in three consecutive policy meetings. But because it is doing so in a weakening economy, it will face criticism for damaging not just domestic economic well-being, but also global growth.
This unfortunate situation the Fed is in — damned if you do, and damned if you don’t — is illustrative of a deeper issue. Having missed the window when a “soft landing” for the economy was feasible, (that is, lowering inflation without much damage to the economy), the Fed now finds itself distressingly far from the world of “first-best” policymaking. In other words, rather than have at its disposal highly effective, timely and well-targeted measures to battle inflation, this Fed has ended up in a world in which virtually all its policy actions can cause significant collateral damage and unintended adverse consequences. Many politicians, companies and households risk thinking of the Fed as part of the problem and not part of the solution.
What is likely to be a record third straight 75 basis-point hike comes against the background of damaging cost-of-living increases that have been broadening in scope and, making things even worse, becoming more embedded into the structure of the economy. Headline inflation, currently at 8.3%, may be falling, but the core rate, which excludes more volatile categories like food and gas, is still rising. And it is the latter, currently at 6.3%, that measures the breadth and likely persistence of inflation.
Yet, for almost all of last year, the Fed consistently downplayed the inflation threat. Meanwhile, the economy continued to be conditioned to operate under zero interest rates; and markets continued to be comforted by repeated Fed intervention to offset equity price declines (the so-called “Fed Put”).
But it was not until the end of November of last year that the Fed stopped assuring us, repeatedly, that inflation was “transitory.” Just a few months ago, it was still pumping liquidity into the economy while inflation was rising fast.
Now, the Fed realizes that it has been very tardy in responding. By allowing inflation to become more embedded — or, as Chair Jerome Powell said last month, “to spread through the economy” — the Fed must now be much more aggressive than it would have had to be if it had responded in a timely fashion. The Fed also needs to avoid another hit to its already damaged reputation and policy credibility.
Rather than lead markets in battling inflation, the Fed has been forced to follow them. Until Powell’s hawkish pivot last month during the Jackson Hole Economic Symposium, it had been repeatedly forced to revise policy guidance to make it more consistent with what markets had been signaling. Coming together with seemingly endless one-way revisions in key economic forecasts (higher inflation and lower growth), this has unfortunately changed the Fed’s economic and financial role from trusted leader to scrambling laggard.
Yet, because it has been so late in responding, the Fed will be aggressively hiking into a weakening domestic and global economy. Thus, there is an increasing number of economists warning that the Fed will tip the US into recession; and a growing number of foreign policymakers complaining that the world’s most powerful and systemically important central bank is pulling the rug out from under an already fragile global economy. This is a far cry from the Fed’s much-celebrated role in helping to avoid extremely damaging global depressions in both 2008-2009 and, more recently, 2020.
This week’s policy action may well end up in three different parts of our economy’s history books: the first time the Fed hikes rates by 75 basis points in three consecutive meetings; another component 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 policy hole that is more familiar to peer institutions in some of the developing world.