Forget all the fancy talk about neutral interest rates and output gaps. The two basic questions facing the Federal Reserve are simple to state and complex to answer: is the world’s most powerful central bank finally committed to return monetary policy to serving the real economy rather than financial markets; and can it do so in an orderly fashion?
These questions are yet to be sufficiently grasped by markets, and for good reason. Viewed from their perspective, the risk for the Fed of not following the market’s lead is too costly. Yet, even if they are ultimately correct, markets will very likely find themselves with much less of an influence on monetary policy than in recent times.
The background to the current situation is well known. For too long, monetary policy has been essentially co-opted by markets. The phenomenon started innocently enough with central bankers’ desire to counter the damage that malfunctioning markets inflict on economic wellbeing. Rather than occurring rarely with well-targeted implementation, massive liquidity injections and floored interest rates developed into a habit.
Over and over again, the Fed felt compelled to use its powerful liquidity-creation weapons to counter asset price declines, even when the risk of disorderly and volatile markets was not apparent. At times, such “unconventional” measures were consistent with the needs of the real economy. Too often, however, they were not.
Like a child successfully throwing tantrums to get more sweets, markets came to expect looser financial conditions whenever there was a strong whiff of instability. This expectation evolved into insistence. In turn, the Fed went from just responding to market volatility to also trying to pre-empt it.
Central bankers were not blind to the unhealthy co-dependencies. The current leaders of both the Fed and the European Central Bank, Jay Powell and Christine Lagarde, tried early in their tenures to change the dynamic. But they failed, and were forced into embarrassing U-turns that made markets feel even more empowered and entitled to insist on the continuation of ultra-loose policies.
Today, however, the two-decade-long market dominance over monetary policy is threatened like never before by high and persistent inflation.
Central banks have little choice but to relegate market considerations in the face of accelerating price increases that severely undermine standards of living, erode the future growth outlook and hit hardest the most vulnerable segments of society.
The situation is particularly acute for the Fed given its gross mischaracterisation of inflation for most of last year, together with its failure to act decisively when it belatedly recognised that price instability had taken root under its watch.
But how best to do so is a problem, given how much the Fed’s delayed understanding and reaction have narrowed the pathway for orderly disinflation. That is, the difficulty of reducing inflation without unduly harming economic wellbeing has only increased. For that, the central bank should have initiated the policy pivot a year ago.
If the Fed now validates the aggressive interest rate rises that markets anticipate, starting with a 50 basis point increase when its top policy committee next meets on May 3-4, it risks seeing them price in yet more tightening. The outcome of this dynamic would be an even bigger policy mistake as the Fed pushes the economy into a recession.
If, however, the central bank fails to validate market pricing, it could erode its policy credibility further. This would undermine inflation expectations, causing the inflation problem to persist well into 2023 if not beyond.
The situation is made more complicated by the likelihood that these two alternatives would result in a degree of financial instability in the US and elsewhere. Even worse — and this may well be the most likely outcome — the Fed could flip-flop over the next 12 to 24 months from tightening to loosening and then tightening again.
The Fed may characterise such flip-flopping as nimbleness but it would prolong stagflationary tendencies, weaken its institutional standing and fail decisively to return monetary policy to the service of the real economy. And for those in the markets that would deem this a victory, it would probably prove a fleeting one at best.
The time has come to return monetary policy to the service of the real economy. It is a far from automatic and smooth process at this late stage. Yet the alternative of not doing so would be a lot more problematic.