Several consequential issues remain for the Fed to make progress on if it wants to transition from being part of the problem of economic and financial malaise to being part of the solution. Here are my top four:
Regaining the policy narrative through credible forward policy guidance on rates
Lacking credible policy guidance from the Fed and witnessing inflation numbers that have tended to consistently surprise on the upside, markets have rushed to price in a historically aggressive interest rate path for this year. The more Fed officials have shifted to an increasingly hawkish narrative to catch up with market pricing, the more markets have tilted to pricing in not just more increases put also a bigger front-loading of them. By early this week, market pricing implied three consecutive 50-basis-point increases.
The Fed desperately needs to regain control of the policy narrative if it is to have any chance to land the economy softly. Time and time again, the Fed has failed to influence markets with clear and credible policy guardrails.
The more the Fed continues to chase markets in vain, the higher the probability of another serious policy error as it is forced into one of two corner alternatives: either validate market expectations and risk a costly recession or disappoint them and further deanchor inflationary expectations.
Establishing a pathway for quantitative tightening
Markets will look for signals on the timing and magnitude of the Fed’s balance sheet reduction. Absent such signals, there is a growing concern that QT could, in itself, disrupt both market stability and economic well-being.
This is harder than it sounds. Having ballooned its balance sheet to $9 trillion, there is no historical playbook on how to manage a gradual and orderly reduction.
The challenges are compounded because the Fed, already so late in recognizing the inflation problems and taking the required policy actions, now has to simultaneously shrink its balance sheet and raise interest rates. Indeed, with time as an enemy, the Fed will need a lot more skill and luck to avoid a problem of underspecification becoming one of overspecification.
Switching from a reactive policy reaction function to a proactive one
The so-called data-dependent Fed is long overdue to pivot from a heavily reactive monetary policy framework to a more proactive and forward-looking one. This requires more than just words regarding its policy reaction function. The Fed must either evolve its “new monetary framework” or revert to what was in place before August 2021.
Again, this is easier said than done.
It takes time to evolve a framework that was designed for a world of deficient aggregate demand but has been carried out in a world of deficient aggregate supply. While the alternative of reverting to the earlier framework is less time consuming, it would involve yet another embarrassment for a Fed dealing with damaged credibility.
Owning up to the mistakes of the recent past
Unlike the European Central Bank, which issued a bulletin on this last week, the Fed has yet to release an assessment of why its forecasting tools failed so badly to predict inflation in 2021 and so far in 2022.
Without such an assessment, together with an explanation of how the tools have been improved, the Fed’s damaged inflation credibility will remain an obstacle to its effectiveness in containing unsettled and increasingly unanchored inflationary expectations. While the set of market-implied and survey measures of future inflation vary, they agree on one thing: Inflation is likely to stay above the Fed’s 2% inflation target for several years.
None of these challenges are easy. Leaving them unaddressed will only make the future of inclusive high economic growth and genuine financial stability even more elusive.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management. His books include “The Only Game in Town” and “When Markets Collide.”
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