The risk of a flip-flopping Fed
The writer is president of Queens’ College, Cambridge, and advisor to Allianz and Gramercy
Markets are changing their minds about the US economic outlook just as the Federal Reserve is making renewed efforts to catch up on the ground.
This risks another round of unnecessary economic damage, financial volatility and greater inequality. It also increases the likelihood of a return to the ‘stop-go’ policy-making of the 1970s and 1980s, which exacerbates rather than tackles growth and inflation challenges.
Good central bank policy making requires the Fed to lead the markets rather than lag behind, and for good reason. A well-informed Fed with a credible vision for the future minimizes the risk of disruptive financial market overshoots, enhances the potential for forward guidance on policy, and provides an anchor of stability that enables productive physical investment and improves the functioning of the real economy.
In the second half of June, the Fed has already lagged the markets twice in the past 12 months, in a consistent manner. First, it stubbornly stuck to its ‘transient’ mischaracterization of inflation until late November, which allowed the inflation drivers to broaden and become more entrenched. Second, after a late price correction on the characterization, it failed to act in a timely and decisive manner — so much so that it still injected exceptional liquidity into the economy the week of March, when the US printed a 7 percent plus inflation rate.
These two missteps have resulted in persistently high inflation which, at 8.6 percent in May, is hampering economic activity, placing a particularly heavy burden on the most vulnerable populations, and contributing to significant market losses on both stocks and government bonds. Now a third misstep may be in the making, as evidenced by last week’s developments.
After being rightly concerned that the Fed is underestimating the threat of inflation and failing to develop its policy stance in a timely manner, markets are now feeling that a belated central bank rushing to catch up, the US economy into recession. This contributed to sharply lower government bond yields last week, just as Fed Chairman Jay Powell appeared in Congress with the newly discovered belief that the fight against inflation is “unconditional.”
Markets are rightly concerned about a greater risk of a recession. While the US job market remains strong, consumer confidence has declined. With business confidence indicators also declining, there is growing doubt about the private sector’s ability to propel the US economy through the major uncertainties associated with this high inflation phase.
Other drivers of demand are also under threat. Fiscal policy momentum has shifted from an expansionary to a contracting stance and exports are battling a weakening global economy. With all of this, it’s not hard to see why so many are concerned about another Fed misstep that is sending the economy into recession.
In addition to undermining socio-economic well-being and fueling worrying financial instability, such a misstep would undermine the institutional credibility so critical to the effectiveness of future policies. And it’s not as if the Fed’s credibility hasn’t already been damaged.
In addition to lagging behind economic developments, the central bank has been repeatedly criticized for its projections for both inflation and employment — the two components of its dual mandate. A recent illustration of this was the skeptical response to the Fed’s monetary policy update released on June 15.
The scenario of concern to the market – the Fed is aggressively raising rates and must be forced to roll back by the end of this year due to the threat of a recession – is certainly a possibility, and it is not reassuring.
There is another equally possible alternative, if not more likely and more damaging in economic and social terms: a multiple flip-flopping Fed.
In this scenario, a Fed without credibility and sound forecasting would fall into the classic “stop-go” trap that haunted many Western central banks in the 1970s and 1980s and remains a problem for some developing countries that are not today have policy conviction and commitment. This is a world in which policies are alternated with the whiplash, seemingly alternating between lower inflation and higher growth, but with little success on either. It is a world where the US is entering 2023 with both problems leading to more disruption to economic prosperity and greater inequality.