Mohamed El-Erian: Fed takes a positive turn, but needs to be done

This new measure goes double-tailed: some perceive it as a tough-minded turn from the Fed, and others as a big reset. In just one meeting, the Federal Reserve’s policy committee abruptly dropped its characterization of inflation as “transitory” to label it as the “enemy # 1” of economic recovery.

This change, although seemingly abrupt and drastic, is very necessary and very welcome. That is the good news. What’s not so great is that it is not bold enough, at least for the moment, and in particular because it is so late. In the face of inflation that proves to be much higher and persistent than the central bank’s repeatedly revised upward forecasts, The institution’s president, Jerome Powell, announced Wednesday a faster pace in reducing its monthly asset purchases (the famous process known as “tapering”).

The Fed also noted the likelihood of a more aggressive initial rate hike cycle, and also that “significant progress” has been made on “peak employment,” the other component of its mandate. The markets’ immediate response was apparently curious, especially for those who perceived a harsher tone with the Fed’s turn than consensus expectations. There was a relaxation of financial conditions rather than a tightening.

The sharp rise in equities came hand in hand with some reduction in the yields of government securities, a fact that led a well-known reporter to argue that the markets had not correctly internalized the message of the Fed. have not fully understood the stated policy of the Fed. Indeed, that is a better explanation than the narrative that markets are pricing in the effects of a worsening growth outlook globally due to the rapid spread of the omicron variant, which is inducing more governments to tighten restrictions on health issues. That would be consistent with what happened to government returns after the policy announcement, but it would go against the parallel global movement of stocks. My view is that market reactions seem a lot less curious if one It looks at where the Fed should be, and not where it comes from.

In fact, it is enough to compare those reactions with what happened on Thursday after the decision of the Bank of England – which is considered to be a leader among its peers in understanding the dynamics of inflation and its political implications – to raise interest rates. by 15 basis points at 0.25%. Yields on UK 10-year bonds rose as equities edged their gains. Powell’s characterization of inflation and employment on Wednesday is at odds with maintaining a policy approach that remains incredibly expansive.

Furthermore, he pointed out in his press conference that the Fed’s monetary policy measures are influenced by its sensitivity to financial volatility, which inadvertently reinforces the opinion in the markets that if things get complicated, the Fed will have no more. remedy than to withhold some form of monetary policy that has proven so profitable for investors.With its large and continuing aversion to market volatility, the Fed risks making the policy transition even more challenging, primarily from two ways. You also run the risk of improperly affecting livelihoods. In fact, sadly, this could remain the standard. First, the initial set of monetary policy announcements and signals is not robust enough to stop the change in inflation dynamics.

Inflation is now spurred not only by supply bottlenecks, particularly supply chain disruptions and labor shortages, but also by changing behaviors of households and businesses. That makes its drivers broader and more durable. Second, Wednesday’s move is not bold enough, and it helps asset prices further decouple from underlying fundamentals when global growth prospects turn. more uncertain.

Let’s just think about what would happen if the growing possibility of stagflation, which remains a tail risk rather than the standard, were discounted by markets rather than sidelined by continued Fed support and capture. Fed is clear. While very welcome, the policy shift is just the beginning and will need to be strengthened in the coming weeks.

In fact, I wouldn’t be surprised if, looking at the markets’ reaction, some Fed officials regret not having gone further this week, especially considering what the Bank of England did despite the UK facing a more uncertain growth outlook.