Consider the Federal Reserve. After misdiagnosing inflation last year and falling behind on its price stability mandate, the central bank has stepped up its policy response significantly in recent months. June’s 75 basis point rate hike was the first of this magnitude in 28 years, and the Fed followed with two similar increases, a record, with a third expected at its meeting next week.
This cycle of Fed rate hikes, which has already generated a total of 3 percentage points in just over six months, is the most intense in a long time. The cooling of the housing market, the strong appreciation of the dollar and the headaches caused to many countries in the world are examples of its effects.
Yet, given the Fed’s slow response, financial markets are pricing in an additional 1.75 to 2 percentage points of rate hikes for this cycle. Building on President Jerome Powell’s repeated references to Paul Volcker, the 1980s central banker famous for crushing inflation, many expect high rates to persist for some time.
No wonder so many have lamented that, having to catch up, the world’s most powerful central bank risks plunging the US economy into recession, putting millions of people out of work, worsening income inequality, undermining its independence and causing economic fires. around the globe. This is a concern amplified by an operational approach that relies heavily on lagged data and still seems governed by an outdated monetary policy framework. Yet equally worrying is the possibility that an early “pivot” in Fed policy could leave the United States languishing in a stagflationary swamp.
This delicate balance between reducing inflation and limiting the impact on economic well-being becomes even more complex due to financial stability concerns, including pronounced threats of dysfunction in government bond markets. of the G-7 at the heart of financial intermediation. The weakest links in the leverage-intensive and derivatives chains have migrated from banks to non-banks that are both less well supervised and less regulated – a phenomenon that was clearly illustrated a few weeks ago by the quasi -collapse of companies serving the British pension system. system.
The faster the rate hike cycle, the greater the risk of major financial crashes with unpleasant economic fallout. After all, the financial system did what it was prompted to do for more than a decade during which markets were conditioned to believe in the longevity of a political regime that set rates at zero or negative rates, injecting trillions of dollars of liquidity and reinforcing belief in a “central bank put option” that protected markets not only from sharp declines in asset prices, but also from what was once considered volatility normal.
The optimization of this regime by the financial system involved significant indebtedness and leverage; excessive adherence to unrealistic performance goals; and, for too many, venturing far beyond their natural investment habitat and expertise. After all, even though the bias of each of these factors was distorted and artificial, it seemed to be influenced very favorably by central banks’ provision of the three things that matter most to investors: high returns, low volatility and favorable correlations.
Inflation and the changes in monetary policy it entails require an orderly reversal of this prior optimization – which is much easier said than done. This naturally fuels concerns about the pace of Fed rate hikes (as well as the fallout from Japan’s experiment in yield curve control, but that’s for another article). If the Fed is not careful, well-intentioned policy actions could end up causing not only an economic crash (recession), but also a financial crash (disorderly deleveraging and disruptive contagion through the financial system and the real economy).
In theory, the Fed’s growth and financial stability challenges could be resolved without harming the fight against inflation by convincing markets that the destination of rates remains the same but the journey will be cautiously slower. In practice, it’s difficult for a central bank which, to quote the Atlanta Fed chairman, is already associated with a “frankly disappointing lack of progress in reducing inflation”. The Fed is increasingly stuck in a three-dimensional rock-versus-hard-spot situation.
It is time to recognize that the rate at which interest rates rise for longer, while necessary to rein in inflation, significantly increases the risk to financial stability. If only all the earlier talk of transient inflation, soft landings and pristine disinflation hadn’t delayed policymakers’ reactions and associated market repositioning.
Now that the tide is no longer in its favour, the Fed will need even more skill and a lot more luck to navigate such a complex inflation-growth-stability setup.
More from Bloomberg Opinion:
• Fed officials must stop talking out of turn: Editorial
• Why breaking the QE addiction is such a struggle: Daniel Moss
• Krugman-Summers Inflation Dispute Explained: Karl W. Smith
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and President of Gramercy Fund Management. He is the author of “The Only Game in Town”.
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