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Bold policy response needed to restore Fed credibility on inflation

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

Suggesting that the US Federal Reserve needs to stop lagging behind inflationary developments on the ground is the polite way of describing what the world’s most powerful central bank must do when its policy committee meets this week.

More bluntly, the Fed needs immediately to stop its asset-purchase programme, guide markets towards expecting three and possibly more interest rises this year and bring forward to March the announcement of plans to reduce its balance sheet. It also needs to explain how it has managed to get its inflation call so wrong and why it is so late in reacting properly.

Without that, it will struggle to regain the policy narrative and restore its credibility.

Since the policy-setting Federal Open Market Committee last met on December 14-15, the US headline consumer price index breached 7 per cent. The core measure of rising prices has gone above 5 per cent with broadening drivers. Unemployment has fallen below 4 per cent while labour force participation has remained unchanged, stuck below pre-pandemic levels.

Moreover, the Fed’s estimate for its preferred measure of inflation — the core personal consumption expenditure index — for 2021 is 4.4 per cent, more than double what it projected a year ago, and the 2022 forecast has been raised to 2.7 per cent. Further upward revisions in 2022 are surely on the cards.

All these data points speak directly to the Fed’s mandate. They suggest that monetary policy should no longer be accommodating. Yet it is still uber stimulative, and on track to remain so for a while.

Rather than tapping on the brakes, the Fed still has its foot on the accelerator: real interest rates after taking into account inflation are extremely negative. While it is on course to stop its quantitative easing stimulus programme at the end of this quarter, it continues to inject funds into a marketplace sloshing with liquidity.

No wonder financial conditions have remained historically loose despite a dramatic shift in analysts’ policy calls since Fed chair Jay Powell belatedly “retired” the “transitory” characterisation of inflation at the end of November.

Forward-looking inflationary pressures continue to be fuelled not just by producer price increases still to make it through the system but also by persistent labour shortages, more supply-side disruptions and a further 10 per cent leg up in oil prices in January.

Having grossly mischaracterised inflation for most of 2021 and missed one policy window after another, the persistently late Fed policy reaction risks what Powell himself warned is a “severe threat” to livelihoods. Accordingly, at its meeting this week, it should send a clear message that it is serious in addressing inflationary pressures.

This should be done via an immediate ending of QE, forward guidance on three interest rate rises and signalling that the balance of risks has tilted to tighter policies. The Fed should schedule for March the announcement of its “quantitative tightening” plan.

To make all this credible, officials must also come clean on why they so badly misread inflation for so long (as noted before, I believe this will go down in history as one of the central bank’s worse inflation calls), and explain how they are now better at incorporating a broader set of bottom-up indicators into its macro modelling and forecasts.

This is what I believe the Fed should do. I worry that it won’t, however.

Marked by the experience three years ago when market volatility forced it into a U-turn (that is, reverting to more accommodative monetary policy even though the economy did not warrant it), the Fed may well favour a more gradual approach.

Indeed, there is a window for such an approach to deliver an orderly adjustment in policy that avoids some combination of prolonged hot inflation, a slowdown in economic growth and unsettling financial volatility. But that window is very small and highly risky.

Judged in terms of risk scenarios, the threat to society is one of a persistently slow Fed being forced later this year into an even bigger bunching of contractionary monetary measures. The result would be otherwise avoidable harm to livelihoods, greater financial instability, a higher risk of domestic stagflation and a greater threat to global economic and financial wellbeing.

The Fed has an opportunity this week to catch up to realities on the ground and regain some of its lost credibility. To do so, it will need to be bold. Continuing on its current path risks another, significantly more disruptive policy error later this year.

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