The Fed fails in four ways

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Watchers of the global economy and market participants will be paying close attention next week to how the Federal Reserve describes the U.S. economic outlook, how big its interest rate hike is, and whether it changes the rate of contraction of its balance sheet. Yet, for the well-being of the U.S. and global economy, the answer to these questions is less important than the Fed’s willingness to fix four failures that continue to fuel one of the worst policy mistakes in decades: analysis, prediction, response and communication failures.

First, what seems to be of most interest to economists and markets at the moment?

On the economic outlook, the Fed will acknowledge that once again inflation has proven to be higher and more persistent than expected and that, despite some signs of weakness, the US economy remains in a “good position”. With that, it is likely to raise rates another 75 basis points and leave its previously announced quantitative tightening plans unchanged.

This will provide relief to those who fear that the Fed, playing a desperate game of catch-up, will raise rates by 100 basis points and worsen what is already an uncomfortably high risk of tipping the US economy into recession. Yet such relief will again prove fleeting unless the Fed also regains its political credibility by addressing its four persistent failures.

The first is that of analysis. The Fed has yet to make the full analytical shift from a world dominated for years by deficient aggregate demand to today’s world where deficient aggregate supply plays a significant role. Its approach to monetary policy is either still formally governed by the “new framework” adopted last year which is no longer suitable and should be publicly abandoned, or governed by no framework at all, leaving the US and global economy without an essential anchor.

The result is a central bank that continually struggles to properly inform and influence economic agents, that consistently lags the markets rather than ahead, and that could easily fall prey to the even more catastrophic policy error of reverting in the trap of the 1970s “stop-go” policies.

To illustrate the Fed’s inadequate policy anchoring, consider the market’s recent implied forecast of what it will announce on Wednesday. In just a few days, the likelihood of a highly unusual 100 basis point Fed hike went from insignificant to even odds, and back to unlikely again.

The longer the Fed resists the expected analytical pivot, the more its inflation and growth forecasts will continue to miss the mark, compounding the second failure. In recent quarters, such projections have been quickly and correctly dismissed as unrealistic by a wide range of economists, market analysts and, more unusually, former Fed officials. This matters even more now that the US economy is showing signs not only of weakening, but also of flirting with a recession.

Third, the Fed needs to be more agile in its policy responses. It is now widely believed that after sticking too long to his misguided call for “transitional” inflation, he should have reacted more forcefully when he finally “retired” that misguided characterization. This was confirmed by former Vice Chairman Randal Quarles last week, who also raised the concern that I and many others hold that the Fed is still being co-opted by the markets.

Finally, the Fed needs to be more direct in its communication. It seems to remain the central bank of the advanced countries most prone, in the words of former Chancellor of the Exchequer Rishi Sunak, to “fairy tale economics”; and it is the most systemically important of all these central banks.

Regardless of what the Fed does next week, without addressing these four shortcomings, the central bank will continue to lack the credibility to avoid being remembered by economic historians as needlessly causing a recession in the United States; having destabilized a global economy still trying to recover from Covid; have aggravated inequalities; fueling troubling financial instability; and contributing to debt stress in fragile developing countries.

More other writers at Bloomberg Opinion:

• The strong dollar is a vote of confidence in the United States: Tyler Cowen

• Data-driven Fed lacks data to change plan: Jonathan Levin

• What it will take for the Fed to control inflation: Bill Dudley

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and President of Gramercy Fund Management. He is the author of “The Only Game in Town”.

More stories like this are available at bloomberg.com/opinion

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