Editor’s note: Mohamed A. El-Erian is president of Queens’ College at the University of Cambridge, Renee Kerns Professor at the Wharton School of Business, a senior fellow at the Lauder Institute, and an advisor to Allianz and Gramercy. He serves on the boards of Barclays, NBER and Under Armour. The opinions expressed in this comment 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. Driven by concerns about high and persistent inflation, the Fed is likely to go down in history as having raised interest rates by the same large amount at three consecutive policy meetings. But because it is doing so in a faltering economy, it will face criticism for harming not only domestic economic well-being but also global growth.
This unfortunate situation the Fed finds itself 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 (ie, lowering inflation without doing much damage to the economy), the Fed now finds itself disturbingly far removed from the world of “first best” policymaking. In other words, instead of having highly effective, timely, and well-targeted measures available to fight inflation, this Fed has ended up in a world where virtually all of its policy actions can cause significant collateral damage and unintended adverse consequences. Many politicians, companies and households risk seeing the Fed as part of the problem rather than part of the solution.
What is likely to be a record third consecutive 75 basis point increase comes against a backdrop of damaging cost-of-living increases that are spreading and, to make matters worse, becoming more embedded in the fabric 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 the latter, currently at 6.3%, measures the breadth and likely persistence of inflation.
Yet for almost all of last year, the Fed has consistently played down the threat of inflation. Meanwhile, the economy was still conditioned to operate under zero interest rates; and markets were still comforted by the Fed’s repeated interventions to compensate for falling stock prices (the so-called “Fed Put”).
But it was only at the end of November last year that the Fed repeatedly stopped assuring us that inflation was “transient”. Just a few months ago, it was still pumping liquidity into the economy while inflation was rising rapidly.
Now, the Fed realizes it was late in responding. Allowing inflation to become more entrenched — or, as the chairman Jerome Powell he said last month, “is spreading through the economy” – the Fed now has to be much more aggressive than it would have had to have reacted in time. The Fed also needs to avoid another blow to its already tarnished reputation and policy credibility.
Instead of leading the markets in the fight against inflation, the Fed was forced to follow. Until Powell’s hawk last month during Jackson Hole Economic Symposium, was repeatedly forced to revise policy guidance to make it more consistent with what the markets were signaling. With seemingly endless one-way revisions to key economic forecasts (higher inflation and lower growth), this has unfortunately changed the Fed’s economic and financial role from trusted leader to laggard.
However, since it is so late to respond, the Fed will aggressively move to weaken the domestic and global economy. Therefore, there is a growing number of economists who warn that the Fed will lead the US into recession; and a growing number of foreign policymakers who complain 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-vaunted role in helping to avoid the extremely damaging global depressions of 2008-2009. and, most recently, in 2020.
This week’s policy action could end up in three different parts of our economic history: the first time the Fed has raised rates by 75 basis points in three consecutive meetings; another component of the biggest central bank policy mistake in many decades; and an unusual example of a developed country’s central bank finding itself in a political hole more familiar to similar institutions in some developing countries.