A bold policy response is needed to restore the Fed’s credibility on inflation

The author is the Principal of Queen’s College, Cambridge and an advisor to Allianz and Grammys

Suggesting the Fed needs to stop lagging behind actual inflation developments is a polite way of describing what the world’s most powerful central bank has to do when it comes to its policy committee see you this week.

More candidly, the Fed needs to stop its asset purchase program immediately, guide markets to expect three rate hikes this year, and possibly more, and bring forward plans to shrink its balance sheet to March. It also needs to explain how it managed to get the inflation call so wrong and why it has been slow to respond properly.

Otherwise, it will struggle to regain the policy narrative and restore its credibility.

Overall U.S. consumer prices have risen since the policy-setting Federal Open Market Committee last met on Dec. 14-15. over 7%. The core indicator of price increases has exceeded 5% as the drivers have expanded. The unemployment rate has fallen below 4%, while the labor force participation rate has remained unchanged and remains below pre-pandemic levels.

In addition, the Fed’s 2021 estimate for its preferred inflation measure — the core personal consumption expenditures index — is 4.4%, more than double the forecast a year ago, while the 2022 forecast has been revised up to 2.7%. A further upward revision in 2022 is certainly possible.

All of these data points directly reflect the Fed’s mission. They suggested that monetary policy should no longer be accommodative. However, it’s still super irritating and will hopefully stay that way for a while.

Instead of hitting the brakes, the Fed is hitting the gas: Real interest rates, adjusted for inflation, are extremely low.Although it is stopping its Quantitative easing In its stimulus package at the end of the quarter, it continued to pump money into liquidity-swaying markets.

No wonder financial conditions remain historically accommodative despite the dramatic shift in analysts’ policy calls since the belated arrival of Fed Chair Jay Powell “retire” The ‘transient’ character of inflation at the end of November.

Forward-looking inflationary pressures continue to be driven by rising producer prices, not only as they still make their way through the system, but also by persistent labor shortages, more supply disruptions, and a further 10% increase in oil prices in January .

have serious wrong description With inflation over most of 2021 and missing policy window after policy window, the Fed’s continued late policy response could risk Powell’s own warnings “serious threat” to livelihood. So at this week’s meeting, it should send a clear message that it is serious about addressing inflationary pressures.

This should be achieved through an immediate end to quantitative easing, forward guidance on three rate hikes, and a signal that the balance of risks has tilted toward policy tightening. The Fed should be scheduled to announce its “quantitative tightening” program in March.

In order for this to be credible, officials also have to clarify why they have misread inflation so badly for so long (as mentioned earlier, I believe this will be one of the historical Central bank calls for worse inflation), and explain how they can now better incorporate broader bottom-up metrics into their macro modeling and forecasting.

This is what I think the Fed should do. However, I’m worried it won’t.

Mark as experience three years ago When market volatility forces it to make a U-turn (ie, even if there is no reason for the economy to return to easier monetary policy), the Fed is likely to favor a more gradual approach.

In fact, this approach has a window for orderly policy adjustments to avoid a prolonged period of high inflation, slowing economic growth and troubling financial volatility. But that window is very small, and the stakes are high.

In the risk scenario, the threat to society is one of the broader monetary tightening measures the Fed is forced to pursue later this year. The result would be avoidable damage to livelihoods, greater financial instability, a higher risk of domestic stagflation, and a greater threat to global economic and financial well-being.

The Fed has a chance this week to catch up with local realities and regain some of its lost credibility. For that, it needs to be bold. Continuing on the current path could lead to another, more damaging policy mistake later this year.

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