Wednesday, February 1, 2023
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The US Fed and the markets should stop talking past each other

Markets rallied after Jerome Powell, chairman of the US Federal Reserve, said Nov. 30 that the world’s most powerful central bank would now slow down its rate hikes. The fact that this remark was balanced by warnings about the uncertain outlook for inflation and policy turned out to be irrelevant to the markets. They heard only good news. This is far from comforting for the Fed, which still needs markets to bring down high inflation. It also doesn’t help counter the political pressure it faces over its inability to respond to inflation in a timely manner, as well as the risks of the economy slipping into recession.

By imagining the following hypothetical tongue-in-cheek conversation between Powell and the financial markets, you can get a good idea of ​​two things: why the Fed is facing a difficult communication problem that matters to the welfare of the US and other economies, and why it is facing a growing political challenge.

Powell: Did you listen to everything I said Wednesday at the Brookings Institution?

Markets: We heard one thing more than anything else. You are definitely going to slow down the pace of interest rate hikes starting this month. You stated quite unequivocally that “the time to slow down the pace of rate hikes may come after the December meeting.” That’s dynamite!

Powell: But I said much more. I issued several warnings about what lies ahead, and therefore pointed out that interest rates would take longer to rise.

Markets: Possibly. But you also mentioned that you’re worried about tightening too much. You haven’t done this in a long time. And it’s not just you. You said directly that these were your colleagues from the FOMC.

Powell: Not so fast. You are too one-sided. You heard me say that there was “more room” to fight inflation and that history clearly speaks of “loosening policy prematurely.”

Markets: We noticed that you told us you were downshifting due to the rate hike before Friday’s employment report. You are obviously very worried about this.

Powell: Wait…

Markets: We also noticed that you didn’t say. You have not tried to counter our massive easing in financial conditions in recent weeks. That being said, we got an even brighter green light from you to weaken them even more by pushing equities up 2-4% on your remarks, depreciating the dollar and lowering bond yields by an average of about 10 basis points, so the 10-year Treasury is now almost 50 basis points lower than a month ago. Of course, this is what you would expect. Massive relaxation of financial conditions.

Powell: No. I expected you to hear all my comments, not just what you wanted to hear.

Markets: Really? But for years we have been forced to expect strong support from the Fed in the form of rates and liquidity. And this is where you seem to have signaled that we are starting to come back, especially now that inflation is no longer an issue. Just look at your predictions!

Powell: Wait, wait, wait. It is too early to declare victory over inflation. Indeed, on Wednesday I said bluntly that we would need “substantially more evidence” before we were sure that the inflation problem was behind us. I also said that our inflation forecasts have proven wrong on numerous occasions.

Markets: But actual and forecast inflation indicators are equally down, and not just in the US.

Powell: It’s one thing when inflation goes down. Another thing is if it returns to our goal of 2%. The problem of inflation was not left out. Then there is a weakening of growth prospects. Of course, this matters for earnings and stock prices.

Markets: Oh, we heard you say something about it. But you have also, at least implicitly, repeatedly reinforced the market consensus that the recession, if it materializes, will be short and shallow. This means that we should just “view it”.

Powell: I just wish the politicians would look at that too. I don’t think they like it when I predict below-trend growth and higher unemployment. They think the Fed can somehow avoid it.

Markets: Well, we sympathize with them.

Powell: What do you mean? You know, of course, that tackling the threat of inflation is critical to high, sustainable, and inclusive growth, which is also consistent with tackling worrisome climate change.

Markets: Yes, but we wouldn’t be in a better position on most counts if the Fed hadn’t characterized inflation as “transient” so badly and for so long; whether the Fed accelerated policy tightening when it finally “dropped” the word “transitory” from its lexicon; and was it therefore forced into a record four consecutive 75 basis point rate hikes?

Powell: Sorry. The time for the power outage before the December policy meeting is approaching.

Mohamed A. El-Erian is President of King’s College, Cambridge and former CEO of Pimco.

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