Fed Forced to Run Triple Option With Time Running Out

(Bloomberg Opinion) -- The final weekend of the regular National Football League season was full of close games, including some with memorable comebacks involving the so-called two-minute drill — that is, the necessity for teams to pivot to a hurry-up offense that holds the promise of winning the game but comes with heightened risk of loss. A similar pivot is in the future of the Federal Reserve — a view that is consistent with what has been a sharp move in analysts’ forecasts of central bank policy actions.

In the last few days, a number of widely followed Wall Street analysts have revised their 2022 expectations for U.S. monetary policy to include the end of large-scale asset purchases, four rate increases and the beginning of balance-sheet contraction.

This revised outlook — which, notably, still means policy would probably remain accommodative overall — is consistent not only with high and persistent inflation but also a labor market that is near maximum employment as measured by Friday’s jobs report — that is, an unemployment rate below 4%, a 0.6% monthly increase in wages and an unchanged labor force participation rate at 61.9%. That situation led Bill Dudley, the former president of the New York Fed, to write for Bloomberg Opinion: “I have news for those who think the U.S. Federal Reserve has turned more hawkish on inflation: It has only just begun.”

This bunching of three tightening measures is highly unfortunate, especially because it was avoidable. It unduly increases the risks of an unnecessary policy-induced hit to livelihoods that would impose a disproportionate burden on the most vulnerable segments of the population. It is the reason some of us advised the Fed as early as April of last year to keep an open mind about the nature of the inflation dynamic and to consider an earlier initiation of its taper. Instead, the central bank’s persistence with a gross mischaracterization of inflation for most of 2021 now means that it has fallen significantly behind developments on the ground and risks the de-anchoring of inflationary expectation that would add a more dangerous driver to a level of annual inflation last experienced during the Volcker era.

In football terms, this is the equivalent of the Fed losing control of the game, having to scramble to catch up and, therefore, being forced into a riskier hurry-up offense — one that increases the probability of interceptions and fumbles.

Because the Fed is moving into uncharted policy waters, it is virtually impossible to answer with a high degree of confidence two key questions: How will the economy respond to the triple removal of monetary accommodation, and to what degree will financial conditions tighten?

These questions are particularly important given how long both the economy and markets have been conditioned to operate not just with highly repressed interest rates but also giant and predictable liquidity injections. And what is in play here is the critical difference between an orderly adjustment and a disorderly one that combines undue damage to the real economy and unsettling financial volatility.

While markets have started to reflect the change in outlook for Fed policy, the extent of this change still trails analysts’ forecasts, let alone where they may end up if Dudley is correct. I suspect that there are two main reasons for this, and both have to do with behavioral conditioning. First, and based on the experience of the last few years, there is doubt as to whether the Fed will have the stomach to sustain the removal of monetary accommodation. Second, too few traders have navigated a world of unanticipated high inflation.

A trip to the playoffs was at stake in several of the weekend’s NFL games in which teams were forced into a hurry-up offense. The stakes are much higher for the Fed and, therefore, for economic and social well-being. The hope is that policy makers will do a Tom Brady and regain control in a reassuring and seemingly automatic manner. The risk, and it is material one and increasing, is that they could end up more reminiscent of my beloved New York Jets.

More From Other Writers at Bloomberg Opinion:

• The Federal Reserve Needs to Get a Lot More Hawkish: Bill Dudley
• Jobs Report All But Ensures a Fed Hike in March: Brian Chappatta
• The Fed Minutes That Shook the World: John Authers

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."

©2022 Bloomberg L.P.