Did the Fed Shift Policy Lanes at the Wrong Time?
(Bloomberg Opinion) -- It has probably happened to many of us. Stuck in a traffic jam and fed up with being in the slow lane, we change lanes only to see our previous one suddenly moving. Do we try to shift lanes again or stick with the new one? The correct answer can’t be known for sure until a lot more distance is in the rearview mirror.
This simple analogy captures for me the situation the Federal Reserve finds itself in with its new monetary policy framework. Like the motorist, it will only become clear down the road, if at all, what the world’s most powerful central bank should have done now.
Reacting to years of undershooting its inflation target, and with the cloud of secular stagnation hanging over the economy, the Fed in early 2019 launched a review of its monetary policy framework. The outcome included not only targeting an average rate of inflation of 2% rather than just getting to 2% — therefore allowing for periods when inflation could run hotter — but also shifting its policy function from preemptive to reactive.
The rationale for this shift was articulated well last week by Fed Vice Chair Richard Clarida in an excellent interview with Bloomberg’s Jonathan Ferro and Tom Keene. With the central bank’s (and many other) models having become less reliable in predicting the future, it made sense to shift from a forecast-based approach to an outcome-based one, he said. And when asked when it could become clear to the Fed that the widely anticipated uptick in inflation this year was not transitory, as Fed officials have insisted it will be, Clarida responded it would be at the end of this year or early next year.
For classically trained economists, this is a possible policy mistake in the making. Long taught that monetary policy operates with “long and variable lags,” such a sequencing of policy actions would risk a bout of inflation that could prove harder to control and reverse than under the traditional preemptive policy approach.
For those who worry about the continued economic uncertainty associated with the pandemic and the associated risk of long-term adverse effects, the latest evolution of monetary policy is not just understandable but also appropriate. The Fed should do all it can now to ensure that both its inflation and employment objectives are met as soon as possible, according to this view. And should it end up with too loose a policy stance, it would be able to regain control by tapping the monetary brakes then.
From a purely economic perspective, I see merit in this second argument. I get uncomfortable, however, when I factor in what this reactive policy approach implies for financial markets, a consideration that has started to gain some appreciation but is still not sufficiently integrated into policy mindsets and design, let alone many of the formal models.
Today’s markets have long been conditioned to operate in a dual environment of consistently low interest rates and ample provision of liquidity by systemically important central banks. The overall level of risk-taking by market participants has surged higher accordingly, and the manner in which it is deployed has broadened.
Margin debt is at record levels. Investors have ventured far from their natural investment habitat to areas they understand less well. While this has allowed all sorts of companies and activities to raise funding with limited due diligence — consider the surge in SPACs and light-covenant bonds as an example — it still widened the already considerable disconnect between finance and the economy, or Wall Street and Main Street. With that has come a series of financial near-accidents this year already.
The Fed’s continued pursuit of a reactive policy approach risks amplifying all of this. Fiscal policy is now highly expansionary, private sector saving is ample on average, consumption is picking up, and the U.S. is accelerating its economic recovery. Absent a significant new headwind from Covid infections and new variants of the virus, the U.S. economy is set to boom this year.
Should this materialize, it will put significant pressure on market interest rates and inflation, undermine the policy credibility of the Fed and risk an abrupt change in policy regime — that is, if a serious financial disruption does not occur before then and contaminate the economy.
When reworking its policy framework, the Fed — indeed, all of us — had no idea that the world would change so drastically because of a pandemic and a complete revamping of demand-management policy. Yet this has happened, and the Fed may now well be operating under a framework that is more suited for the pre-pandemic world than current realities and prospects.
Realistically, the answer is not to embark on yet another institutional exercise to change the framework yet again, especially given remaining uncertainties and the impact on institutional robustness. Rather, it is to adapt its application in two ways: first, by moderating the loud continued commitment to a pedal-to-the-metal policy measures with a view to carefully and gradually removing exceptional monetary stimulus; and second, both on its own and with other government entities, doing more as soon as possible to counter the rising risk of financial instability, in particular from nonbanks.
The Fed had no way of knowing that the slow economic lane it was operating in would suddenly be halted by a pandemic only to be radically unblocked by the rapid adoption of a historic “whatever it takes” and “all in” policy approach. Had it known this, it would have been better to remain in that lane rather than shift. The key now is to quickly adjust the way it operates in the other lane lest it end up in the worst of all possible jams.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include "The Only Game in Town" and "When Markets Collide."
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