Over the last 18 months or so, the quick and easy interpretation of inflation data has turned out to be incorrect. Will it be different going forward? Markets sure hope so. Federal Reserve officials seem more cautious, and rightly so. The markets’ latest narrative pivot is not the right one for the world’s most powerful central bank.
When the inflation threat first reared its ugly head early last year, the Fed, most market participants and analysts found immediate reasons to dismiss it. The drivers were external, tiny in number and historically inclined to be quickly reversible. Opting for the “transitory” characterization was quick and easy to do, especially because it did not require any change in approach. After all, you just “look through” transitory phenomena.
As inflation persisted and accelerated, markets shifted away from the transitory view, but the Fed clung to it until the end of November. By that time, inflation had started to become more deeply embedded in the economic system, and its drivers were broadening.
With the Fed finally raising interest rates and mapping out a path for quantitative tightening through balance sheet contraction, both policy makers and many market analysts and participants opted initially for a “soft landing” outcome — that is, the ability to reduce inflation without much damage to growth. Again, it was quick and easy. And, again, it proved partial and oversimplistic.
It didn’t take long until markets started to price in a significant risk of recession as the realization spread that, with the Fed having fallen so far behind on inflation, its need to raise interest rates rapidly and aggressively would most likely significantly damage economic activity. Both stocks and bonds sold off sharply, and the yield curve started to invert.
It was time for reassuring words from the Fed about a soft landing to give way to a more cautious tone, along with a more determined policy narrative that included an “unconditional” commitment to defeat inflation. The yield-curve inversion deepened, approaching minus 50 basis points at one point for the spread between two-year and 10-year Treasuries. The Fed indicated that it intended to shy away from forward guidance after its series of embarrassments.
The recent combination of a stronger-than-expected jobs report and better-than-expected inflation numbers has reset the dominant narrative in markets — again the quick and easy thing to do. The decidedly much more constructive economic tone is based on the view that the Fed will be able to complete its tightening cycle in the next few months and even start easing as early as next year, thereby limiting the hit to growth, employment and incomes.
This puts the Fed in a difficult position. Does it follow suit and validate through actions and words the easing in financial conditions being carried out by markets; or does it remain steadfast and risk unsettling markets that have regained their footing after a damaging first half of 2022?
As tempting as it may be to again choose the easy course of action, the Fed should resist yet another approach that risks keeping the inflation threat alive for longer. This would not only result in further erosion of purchasing power but also further damage growth prospects and impose an even heavier burden on the most vulnerable segments of our society.
The Fed needs to stay the course and do its utmost to put the inflation genie back into the bottle. This is not easy, and it is far from risk free. Yet it dominates the other policy alternative available to a Fed that, because of its previous mistakes, no longer has a first-best policy approach at its disposal.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former CEO of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”
