Fed’s High-Wire Act Becomes Trickier

The Federal Reserve’s top policy-making committee will meet this week facing significant crosscurrents: How best to balance a dimmer short-term economic outlook with a brighter longer-term one, and how to maintain highly stimulative monetary policy notwithstanding the prospects of significant fiscal expansion. While the Fed is likely to err again on the side of ultra-dovishness, economic and market issues are increasing the challenges of doing so.

With Friday’s data from purchasing managers being a notable and welcome exception, recent economic reports have pointed to a slowdown in the U.S. economic recovery. A weakening labor market and contracting retail sales highlight a service sector that is again coming under pressure because of direct and indirect disruptions related to Covid-19. While the virus-related measures announced recently by President Joe Biden are greatly needed for the longer-term well-being of America’s public health and economy, they will most likely curtail travel and other activities in the weeks ahead. Meanwhile, Europe is falling into a second-dip recession that is said to have Germany considering a significant downward revision to its projected growth rate for 2021 to around 3% from 4%.

This more difficult short-term outlook stands in contrast to a brighter longer-term one. Vaccine deployment is accelerating, accompanied by the Biden administration’s more serious and better-coordinated effort to slow the spread of infection. The new Covid-19 variants, while a concern, have not been shown to eliminate the beneficial impact of vaccination. Meanwhile, abundant evidence of overstretched hospitals and exhausted health-care workers seems to be curtailing some individuals’ unhealthy behavior.

Then there is the policy front. The design of Biden’s first fiscal package and the flood of executive orders that are preceding its consideration by Congress are signs that the new administration understands and is acting on the importance of the type of  multipronged approach discussed in my earlier columns — that is, making early and simultaneous progress on relief for the most vulnerable segments of society; fighting Covid-19; and easing household financial insecurity. The fourth critical element of such a comprehensive policy approach — taking measures to improve productivity and growth potential — is to be covered by the second fiscal package that Biden has scheduled for February.

Given existing financial conditions and multiplying evidence of excessive risk-taking in markets, the Fed could be expected to tilt its policy guidance toward an earlier gradual taper of its ultra-loose monetary policy stance as the economy gets through the short-term difficulties and the new fiscal stimulus kicks in. The case for such a tilt is strengthened by legitimate concern that markets have been distorted by too many years of ample and predictable liquidity injections, causing them to disconnect excessively from fundamentals while also fueling the already considerable concerns about inequality.

Yet the Fed is unlikely to do so at this week’s FOMC meeting, worried that a premature change in forward guidance could cause financial market dislocations that would undermine an economy facing that dimmer short-term outlook. Indeed, the Fed is more likely to maintain the current guidance indicating that monetary policy will remain ultra loose for at least another year, if not longer.

But such guidance faces increasing questions in the face of a brighter economic medium term, frothy financial markets and the coming considerable fiscal expansion. Considering reasonable estimates of the economic boost from the release of pent-up household demand after effective vaccination and assuming Congress passes most of Biden’s fiscal plans, the incremental demand injections into the economy could amount to some 20% of gross domestic product this year, if not more. With the supply side unlikely to display the same amount of short-term agility, the increase in the overall price level in 2021 could well exceed the Fed’s 2% target.

In such circumstances, many economists worried about longer-term economic scarring would be quick to point out that this is more likely to be a one-time price adjustment rather than the beginning of a destabilizing inflationary process. The Fed would be quick to add that the recent adjustments to its monetary framework targets an average inflation rate and, as such, allows for a deviation above 2% for some period. But will markets listen early and fully enough? If they don’t, the likely upward pressure on longer-term government bond yields would confront the Fed with an even tougher policy dilemma: risk disruption to stocks and other risk markets or be forced into stronger yield curve control with the accompanying threat of even more distortionary spillovers for efficient market functioning, price signaling and resource allocation.

Facing all these crosscurrents, the Fed will hope to stage this week’s policy meeting as an undramatic event for markets. Its success in doing so should not obfuscate, however, the mounting challenges of a macro policy handoff from excessive reliance on central banks to a more balanced policy stance together with more serious measures to improve public health. It is a policy pivot that has been long hoped for and needed; yet the more it has been delayed, the greater its degree of difficulty.

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."

©2021 Bloomberg L.P.

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