The risk of a flip-flopping Fed
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The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy
The markets are evolving their minds about US economic prospects just as the Federal Reserve has been scrambling again to catch up to developments on the ground.
This risks yet another round of undue economic damage, financial volatility and greater inequality. It also increases the probability of a return to the “stop-go” policymaking of the 1970s and 1980s that exacerbates growth and inflation challenges rather than addressing them.
Good central bank policymaking calls for the Fed to lead markets rather than lag behind them, and for good reasons. A well-informed Fed with a credible vision for the future minimises the risk of disruptive financial market overshoots, strengthens the potency of forward guidance on policy and provides an anchor of stability that facilitates productive physical investment and improves the functioning of the real economy.
Coming into the second half of June, the Fed had already lagged behind markets twice in the past 12 months and in a consequential manner. First it stubbornly held on to its “transitory” mischaracterisation of inflation until the end of November, thereby enabling the drivers of inflation to broaden and become more embedded. Second, having belatedly course-corrected on the characterisation, it failed to act in a timely and decisive manner — so much so that it was still injecting exceptional liquidity into the economy in the week in March when the US printed a 7 per cent-plus inflation print.
These two missteps have resulted in persistently high inflation that, at 8.6 per cent in May, is hindering economic activity, imposing a particularly heavy burden on the most vulnerable segments of the population, and has contributed to significant market losses on both stocks and government bonds. Now a third mis-step may be in the making as indicated by developments last week.
Having rightly worried about the Fed both underestimating the threat of inflation and failing to evolve its policy stance in a timely manner, markets now feel that a late central bank scrambling to play catch-up risks sending the US economy into recession. This contributed to sharply lower yields on government bonds last week just as the Fed chair, Jay Powell, appeared in Congress with the newly-found conviction that the battle against inflation is “unconditional”.
The markets are right to worry about a higher risk of recession. While the US labour market remains strong, consumer sentiment has been falling. With indicators of business confidence also turning down there is growing doubt about the ability of the private sector to power the US economy through the major uncertainties caused by this phase of high inflation.
Other drivers of demand are also under threat. The fiscal policy impetus has shifted from an expansionary to contractionary stance and exports are battling a weakening global economy. With all this, it is not hard to see why so many worry about another Fed mis-step tipping the economy into a recession.
In addition to undermining socio-economic wellbeing and fuelling unsettling financial instability, such a mis-step would erode the institutional credibility that is so crucial for future policy effectiveness. And it is not as if Fed credibility has not been damaged already.
In addition to lagging behind economic developments, the central bank has been repeatedly criticised for its forecasts for both inflation and employment — the two components of its dual mandate. A recent illustration of this was the sceptical reaction to the Fed’s update on monetary policy released on June 15.
The scenario that worries the market — the Fed aggressively hiking rates only to be forced to reverse by the end of this year due to the threat of recession — is certainly a possibility, and it is not a comforting one.
There is another equally possible alternative, if not more likely and more damaging economically and socially: A multi-round flip-flopping Fed.
In this scenario, a Fed lacking credibility and sound forecasts would fall in the classic “stop-go” trap that haunted many western central banks in the 1970s and 1980s and remains a problem for some developing countries today lacking policy conviction and commitment. This is a world in which policy measures are whipsawed, seemingly alternating between targeting lower inflation and higher growth, but with little success on either. It is a world in which the US enters 2023 with both problems fuelling more disruption to economic prosperity and higher inequality.