Source: Golden Ten Data

Allianz chief economist El-Erian (El-Erian) recently wrote that the unified position of Federal Reserve officials on interest rates is accompanied by three major risks. Here's his opinion:

Whether traditionally viewed as “hawks” or “doves,” Federal Reserve officials have recently shown significant agreement on policy signals, that is, maintaining high interest rates for a long time. This shift comes against the backdrop of more Wall Street analysts' growing range of uncertainty about their economic growth and inflation forecasts. This situation poses three major risks to economic prosperity and financial stability.

As all major inflation indicators for the first quarter were higher than expected, Fed officials became more cautious about their previous expectations of continued easing of price pressure. Powell summed up this shift last week. He said his confidence in falling inflation was “not as high as it was at the beginning of the year.”

Given a more cautious view of inflation — and the background of 2021 wrongly describing inflation as “temporary” — recent statements by Federal Reserve officials have consistently emphasized that restrictive monetary policies need to be given more time to work. Officials have lowered their expectations for interest rate cuts, saying April's less worrying inflation data was not enough to boost confidence. In fact, as Waller reiterated on Tuesday, Federal Reserve officials are looking for “a few more” good inflation data before considering cutting interest rates.

This consistency does not guarantee smooth sailing for the economy and markets since it comes at a time when confidence in the judgment and effectiveness of the Federal Reserve has shaken. Indeed, three risks stand out in particular.

The first risk relates to the Federal Reserve's high degree of responsiveness in its policy approach. I think this is excessive reactivity, or the Fed's “data-dependent” approach, to use the most popular term at the moment. As a result, the Federal Reserve turned to more dovish signaling in December of last year alone, which in turn gave the market confidence to expect to cut interest rates six to seven times this year. The series of favorable inflation data that prompted that shift was then replaced by less reassuring data in the first quarter. This was followed by a continuous major policy reversal. The market now only expects one or two interest rate cuts.

In a world full of uncertainties, this passive approach is problematic. For an institution where policy instruments are lagging behind and other drivers of inflation are less sensitive to interest rates, the problem is even greater.

The second risk is that this policy shift comes at a time when more and more companies are concerned about weakening consumer demand. This is especially true for businesses serving low-income households, whose pandemic savings have been completely exhausted, credit card balances have increased, and their ability to take on more debt has reached or is close to the limit. Weakness at the bottom of the income ladder began to spread upward, increasing the economy's strong dependence on the labor market.

The third risk is that the Federal Reserve's policy signals are based on an outdated 2% inflation target. Remember, 2% is not the output of some complex econometric model. Instead, it is an arbitrary target that originated in New Zealand in the 1990s and was later adopted by other institutions, including the Bank of England and the European Central Bank. In a world that has enjoyed a series of favorable supply shocks, this goal is mostly non-binding.

As I have argued before, 2% is probably a low target for domestic economic strategies that are no longer anchored by the “Washington Consensus” (that is, liberalization, deregulation, and fiscal discipline). We live in a completely different economic policy paradigm than before. In fact, one need only note the abnormally high budget deficit coexisting with an unemployment rate of less than 4% for 27 consecutive months, as well as the spread of industrial policies and the financial support required for government announcements.

The 2% inflation target is also being challenged by a changing global paradigm. Close integration in pursuit of extreme globalization has given way to fragmentation and the weaponization of trade and investment instruments. This once again turned the long-term anti-inflationary trend into an inflationary trend.

The combination of these three risks means that the current unity of view of Federal Reserve officials, especially if it continues for more than a few months, may unnecessarily weaken the most effective engine of growth in global economic expansion, and will be accompanied by more obvious currency and interest rate fluctuations, hitting parts of the economy that are overindebted, such as commercial real estate.

The question of future monetary policy is not whether the Federal Reserve will change its gossip again. What is almost certain is that for the US Federal Reserve, which still lacks strategic support, another 180-degree turn is very likely, and when economic growth slows more than policymakers' expectations or acceptance, the Fed's response will lag behind. The key question is whether this situation can avoid significant economic and financial losses, particularly for the most vulnerable segments of the population.

edit/lambor