Fed Needs to Take Action Despite Its Framework

(Bloomberg Opinion) -- Federal Reserve officials, confronting developments and an outlook they seem to have not anticipated, face tricky decisions as they finalize their policy deliberations on Wednesday. These center on updating their individual projections and converging on whether — and if yes, how — to start a necessary policy pivot that unfortunately conflicts with the framework the central bank adopted recently to guide and signal monetary policy intentions.

If they were market traders or CEOs of competitive private companies, the answer would be clear: Start reducing exposure to a now more risky posture by moving forward with a partial pivot in light of the changed circumstances, thereby keeping their options open and better balancing risk. That is not what is likely to transpire, however. Instead, the Fed will most likely fall short of what is required and risk exacerbating the challenges it — and the economy — face in the longer term.

Like many others, the Fed’s projections had anticipated a slower economic recovery with inflation limited to temporary and rapidly reversing “transitory” factors such as base effects and demand-supply imbalances. In such a world, the new policy framework adopted in 2019, which involves a shift from forecast-based to outcome-based policy actions, would have been appropriate, providing the Fed with a foundation for a warranted multiyear glide path for a very slow and orderly policy transition.

Under this scenario, I suspect that the earliest the Fed would have initiated broad conversations about tweaking its policy signaling would have been at the end of August during the Jackson Hole Symposium of central bankers in Wyoming — reinforcing their strong desire to avoid a repeat of the disruptive 2013 “taper tantrum” and the embarrassing policy U-turn at the end of 2018 and the start of 2019. Following that would have been a multimonth period of designing a taper, an equally long period of actual gradual taper in 2022 and the initiation of a cycle of very gradual rate increases in 2023 and 2024.

What is transpiring so far, however, is a persistently much hotter inflation outlook and, with that, the need for an accelerated timeline. The evidence is piling up, and not just for the Fed. The Labor Department reported on Tuesday that the producer price index rose to a 6.6% gain on an annual basis, above consensus expectations. That followed higher-than-expected readings last week in China’s PPI and the U.S. consumer price index. 

With the supply side under growing pressure, more companies are fearing longer-term disruptions to supply chains, worker availability, transportation and inventory management. Some are also increasing wages to both attract workers (the Job Openings and Labor Turnover Survey reports record demand) and retain them (quit rates are also at a record high). The inclination to pass through these increases to prices is considerable, aided and abetted by the greater pricing power that several companies possess coming out of the pandemic because of both supply changes such as industrial concentration and abundant demand.

In such an environment, the world’s most powerful central bank should ease its historically astounding policy stimulus. This would start immediately with a small taper of the $120 billion of monthly asset purchases — a prelude to their eventual elimination over the next 12 months— and the subsequent start of a slow lifting of interest rates from near zero. The argument for launching this policy adjustment immediately is reinforced by how record loose financial conditions have encouraged and enabled excessive and, in some instances, irresponsible risk-taking.

Unfortunately, the policy transition will probably be delayed further given the interactions of the backward-looking framework, confirmation biases, active inertia and the extent to which reputations have already been invested in what has been a frequent reiteration of the two mantras of “transitory inflation” and “not thinking about thinking” about tapering. But the longer the Fed delays, the greater the threat it will be forced to slam on the policy brakes down the road. This would, in turn, risk both an economic recession and financial market instability. In addition to the undermining economic and social well-being, it would complicate the administration’s economic reforms and create adverse spillover effects for other countries, especially in the developing countries.

With markets living in the moment, a financially quiet summer is still possible, as is continued public and private sector complacency. Yet unless the Fed signals in the next few months an acceleration of its reaction function, the risk would increase that this could end up being the calm before the storm instead of the solid foundation for the high, durable, inclusive and sustainable growth that is needed coming out of a tragic pandemic. 

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.