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Mohamed El-Erian: Fed must resist going for the quick and easy

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When the threat of inflation first reared its ugly head early last year, the Federal Reserve, most market participants and analysts immediately found reasons to dismiss it.

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The catalysts were external, small in number, and historically inclined to be rapidly reversible. Going for the “transient” characterization was quick and easy to do, especially since it didn’t require any change in approach. After all, it was simply “looking through” transient phenomena.

As inflation persisted and accelerated, markets moved away from the vision of transience, but the Fed stuck with it until the end of November. By this time, inflation had begun to take root more deeply in the economic system and its drivers were widening.

When the Fed finally began to raise interest rates and chart a path for quantitative tightening through balance sheet shrinkage, both central bankers and many analysts and market participants initially opted for a “soft landing” outcome, that is, that is, the ability to reduce inflation without doing much damage to growth. Once again, it was quick and easy. And, again, it was biased and overly simplistic.

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It was not long before markets began to price in significant recession risk as the idea spread that since the Fed had been so late in acting on inflation, its need to raise interest rates quickly and aggressively would likely significantly damage economic activity. Both stocks and bonds fell sharply and the yield curve began to invert.

It was time that the Fed’s reassuring words about a soft landing gave way to a more cautious tone, along with a more determined policy narrative that included an “unconditional” commitment to rein in inflation.

The yield curve inversion deepened, with the spread between 2-year and 10-year Treasuries at one point reaching less than 50 basis points. The Fed indicated that it intended to stop providing forward guidance after a series of blips.

The recent combination of a stronger-than-expected jobs report and better-than-projected inflation figures has reset the dominant narrative in the markets, again which is quicker and easier to do.

The decidedly much more constructive economic tone is based on the view that the Fed will be able to complete its cycle of monetary tightening in the coming months and even begin to ease it next year, thus limiting the impact on growth, employment and income.

This puts the Fed in a difficult position. Does it do the same and validate with deeds and words the easing of financial conditions as the markets are doing? Or is it holding its own and running the risk of destabilizing markets that have regained their footing after a damaging first half?

As tempting as it may be to go back to the easy course of action, the Fed should resist another approach that risks keeping the inflation threat alive longer. Not only would this result in a further erosion of purchasing power, but it would also further damage growth prospects and place an even greater burden on the most vulnerable segments of our society.

The Federal Reserve must stay the course and do everything it can to put the inflation genie back in the bottle. This is not easy and is far from risk free. However, it dominates the other policy alternative available to a Federal Reserve which, due to its past mistakes, no longer has the option of choosing the best approach to monetary policy at its disposal.

Source: Gestion

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