The problem with a persistently late Federal Reserve

Some 15 months after the Federal Reserve started insisting that inflation was transitory and that we shouldn’t worry much about it, the rate of consumer price increases stands at a damaging 9.1 percent and, so far, has become the most consequential economic, social, political and institutional issue of 2022.

This unfortunate setup will result in an aggressive interest rate hike on Wednesday by a Fed scrambling to catch up with realities on the ground. As it tries to do so, however, the inflation issue is evolving once more and, due to the growing risk of recession, is again likely to catch the Fed offside.

What started out as inflation driven by a readily identifiable set of exogenous drives — namely, energy and food prices — has been allowed to become more entrenched and broad-based. Depending on who you ask, the blame game for why this has happened involves several actors with a recurrent one: A Fed that mis-analyzed, badly forecasted, poorly communicated, and inadequately responded to a phenomenon that is consequential for our society in a number of ways.

Desperate to catch up, the Fed is likely to take the unusual step of announcing on Wednesday another 75-basis-point increase in interest rates wrapped in a notably hawkish narrative. Equally unusual, and again a reflection of it being so late in responding, it will do so despite multiplying signs that the U.S. economy is slowing rapidly.

No wonder so many more people are worried that the Fed will push us into what would have been an otherwise-avoidable recession. This concern is a reflection of a larger issue: The current inflation dynamics are changing in a way that is likely to catch out the Fed yet again.

It would not surprise me if the recent 9.1 percent inflation print proves to be the peak for now. Specifically, the question is no longer the one that has been on so many people’s worry list, and rightly so: How high will inflation go in the next three months? It is now evolving to how fast and how far will inflation come down — and, equally if not more important, the extent of collateral damage for the economy.

I fear that, given how out of sync the Fed has been for so long, the downward trajectory of inflation may prove sticky and accompanied by unnecessary damage to livelihoods and a further worsening of inequality.

This is a scenario in which households, especially those with low income, face the double whammy of eroding purchasing power and growing income insecurity. It also is a scenario that risks fueling economic and financial instability internationally, as well as domestically.

Fortunately, it is not totally pre-ordained. Timely and appropriate policy responses can contain the worst of the damage, both to short- and longer-term societal wellbeing.

For the Fed, this requires an urgent step-improvement in addressing the four persistent failures mentioned earlier: analysis, prediction, communication and response. Too much time has already been lost, and at a substantial cost to its credibility and to the economy at large.

Working with other government agencies, the Fed also needs to do more to counter the growing risk of unsettling financial instability. Because of years of ultra-loose monetary policies that have involved zero interest rates and massive direct injections of liquidity, this threat has morphed and migrated from banks to a non-bank sector that has been conditioned to stretch far and wide for returns and, in the process, assume excessive risk.

For the administration and Congress, it means doing more to enhance supply, labor force participation, productivity and growth; targeting fiscal support on the most vulnerable segments of society; and taking the lead in improving global policy cooperation to address economic obstacles that, by their nature, require collective action.

The implications of insufficient progress on this policy agenda would extend beyond a more difficult short-term outlook for the U.S. and for the global economy.

They also threaten to lower our medium-term growth potential, worsen the inequality trifecta (of income, wealth and opportunity), place further pressure on our social and political fabric, and pull the rug from under a crisis-prone global economy.

This also a world that, once again, would distract attention away from dealing with critical secular challenges in climate and health that, year in and year out, are becoming more critical and harder to solve.

Mohamed A. El-Erian is president of Queens’ College, Cambridge University. He is an advisor to Allianz and Gramercy Fund Management, the Rene Kern Professor of Practice at The Wharton School, and a senior fellow at the Lauder Institute of the University of Pennsylvania.

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