Mystical Hold of ‘Transitory’ Tempts Huge Fed Error
(Bloomberg Opinion) -- When inflation started to rise earlier this year, many central bankers were quick to call it “transitory,” asserting that it would dissipate soon. Over the course of 2021, however, neither the quantitative forecasts nor the arguments cited in support of this hypothesis have held up. Yet, in stark contrast with the mindset of corporate leaders who are dealing daily with the reality of higher and persistent inflationary pressures, the transitory concept has managed to retain an almost mystical hold on the thinking of many policy makers. The longer this persists, the greater the risk of a historic policy error whose negative implications could last for years and extend well beyond the U.S.
Initially, the rationale for transitory inflation relied heavily on the quick expiration of both statistical base effects and initial supply-demand mismatches as economies restarted after the sudden stop induced by Covid-19. It minimized — or, more accurately, ignored — the possibility of deeper structural factors such as the rewiring of supply chains and changing attitudes toward work. It also ignored the possibility of renewed economic disruptions caused by a variant-fueled resurgence in Covid infections.
While the base effects did pass, and global production bounced back strongly in the second quarter, inflation indicators continued to worsen as demand remained strong and, more significantly, structural inflationary factors came more into focus. They took a further leg up as the delta variant closed ports in China and Vietnam, further disrupting an already fragile and stretched cross-border supply chain. And, in a further blow to the “transitory inflation” camp, price pressures continued to mount in the third quarter even though global growth started to slow and fiscal stimulus was withdrawn.
Some central bankers, most notably at the Bank of England, have been quicker to internalize these realities and revise their thinking and policy guidance. In contrast, the cognitive transition at the core of the Federal Reserve — regional Fed banks have shown greater awareness — has been remarkably slow and partial, falling ever further behind what the vast majority of companies have been saying and doing as they cope with input shortages, soaring transportation costs and a lack of sufficient workers.
Labor has also received the message. Quit rates have risen to record highs as more workers switch jobs to secure higher compensation elsewhere. In turn, this has been forcing companies to raise wages and salaries for their existing staff as they seek to strengthen labor retention. To compound matters, strike activity is on the increase.
Several factors help explain the Fed’s delayed reactions, starting with behavioral aspects. The central bank has fallen hostage to a specific framing that, unfortunately, it overly publicized and now anchors its credibility and standing. It is a framing that is pleasing to the ears, not only to those of policy makers but also those of the financial markets, but becoming harder to change. The cognitive inertia has been amplified by the ill-timed adoption of a “new monetary framework,” which is built for the macro world of yesterday (that is, deficient aggregate demand) and not that of today (deficient supply). Political factors and posturing may also be playing a role.
Have no doubt, a cognitive transition will be forced on the Fed as inflationary pressures continue to climb and as markets start to question the policy stance more intensely. Indeed, the almost dogmatic adherence to a strict transitory line has given way in some places to notions of “extended transitory,” “persistently transitory” and “rolling transitory” — compromise formulations that, unfortunately, lack analytical rigor given that the whole point of a transitory process is that it doesn’t last long enough to change behaviors. Yet consumer and producer behaviors are already changing in response to high and persistent inflation, as is that of some governments, such as China, and central banks, especially those in developing countries but also in a growing number of advanced economies.
I strongly suspect that the coming evolution in the Fed’s inflation narrative will come with a doubling down on talk seeking to separate, substantially in time and scale, the tapering of large-scale asset purchases from interest rate increases. The longer and harder the Fed forces this distinction, the more likely it will face market resistance as fixed-income investors realize that, rather than deliver a timely and orderly recalibration of monetary policy, the Fed faces an increasing probability of having to slam on the monetary policy brakes down the road — the “handbrake turn,” to borrow a phrase from Andrew Haldane, the former chief economist of the Bank of England.
Such a scenario — of a delayed and partial response initially, followed by big catch-up tightening — would constitute the biggest monetary policy mistake in more than 40 years. It would derail President Joe Biden’s transformational policy agenda and unnecessarily undermine America’s economic and financial well-being. It would also transmit avoidable waves of instability throughout the global economy. It is a risk that still can— and must — be avoided, though the window for doing so is closing fast on the Fed.
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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