The Federal Reserve Continues to Fall Behind the Curve

(Bloomberg Opinion) -- Some observers have characterized the outcome of the Federal Reserve’s meeting on Wednesday as a “hawkish surprise.” That is only the case if expectations were for a policy deliberation that was blind to what has been happening on the ground. Though it failed to take actual policy actions, the central bank at least demonstrated it has been taking note of recent developments:

• Recognizing what has been happening in the economy, the Fed is more optimistic about economic growth. It now also anticipates higher inflation. In both cases, however, the recent upward data surprises have not been sufficiently reflected in the revised forecasts.
• While the Fed is holding on to its “transitory” characterization of inflation, its confidence in this baseline has declined because of supply-side concerns. Such concerns for the Fed extend to the functioning of the labor market in the short term. Again, however, the more persistent elements are underestimated.
• Fed officials’ distribution of expectations for interest rate increases has shifted earlier. The median expectation is now for two hikes by the end of 2023, implying an acceleration of the timetable for discussing the tapering of asset purchases, which would be a preamble to any rate increases.
• Countering the view that the new outcome-based monetary framework is a “straitjacket,” Chair Jerome Powell hinted at the possibility of adding an opportunistic component to the backward-looking framework.

All of this speaks to the greater proximity of an inflection point for the Fed’s ultra-loose policy stance and, with that, a greater challenge for Powell to maintain the unity of the Federal Open Market Committee in the quarters ahead.

The implications for markets vary a great deal depending on the asset class. For example, it involves notable discomfort for mark-to-market and short-term holders of the belly of the U.S. government bond curve (five-year Treasury notes, for example), as well as those short the dollar. It is not particularly painful for holders of risk assets who, living in the “market moment,” will be reassured for now by the Fed’s insistence on a well-telegraphed runway of unchanged quantitative easing for the rest of the year, if not longer.

Most important, however, relative to what is needed, the Fed continues to fall further behind the curve, compounding an unnecessary risk facing a recovery that needs to be strong, long, inclusive, sustainable and not vulnerable to unsettling financial market instability.

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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