By removing the word “transient,” Federal Reserve Chairman Jerome Powell did more than finally correct a gross misstatement of inflation that he had been attached to for too long. He also highlighted inflation as a major risk to the economy and financial markets, not because the prospects for further price increases are inherently problematic (they are not), but because the communication process and the Fed’s policy responses are behind schedule. The catching-up process – and a swift process is needed given the delays so far – could destabilize markets and the economy. It didn’t have to be that way.
For months, Powell claimed inflation was transient. Rather than timely revising his claim in the face of much evidence to the contrary, he adopted an increasingly elastic concept of the word that favored longer and arbitrary periods of time at the expense of economic analytical rigor. This allowed the Fed to continue its massive monthly purchases of market securities at a time when the economy was doing very well, the housing market was hot, and the “whole rally” fueled by liquidity in financial assets was showing signs. increasing excessive risk. -socket.
Investors loved this Fed-driven liquidity paradigm. After all, nothing is more reassuring for the purchase of assets than a very large acquirer with a colossal balance sheet who activates regularly and buys on non-commercial terms. Indeed, the very notion that the Fed has been completely price insensitive as it buys over $ 100 billion each month has effectively made others less value sensitive, further decoupling asset prices from economic and corporate fundamentals. .
Powell’s repeated assurances that inflation was transient led many investors to believe – or, at least, act because this unusual market construction could go on forever. The result was not only record risky assets including stocks and cryptocurrencies, but also high prices for risk-free government bonds (low yields) despite what is believed to be a negative correlation.
The president’s sudden abandonment of transient inflation just days after his appointment by President Joe Biden came as a shock to the markets on Tuesday. Stocks collapsed, yields on short-term US government bonds rose, and commodities fell. It didn’t help things that Powell chose to turn around on inflation just as markets were trying to gauge what the emergence of the omicron, a new variant of Covid considered to be more infectious. and perhaps even evasive for vaccines, meant for economic activity.
The problem now is that such a late awakening to the reality of inflation increases the risks of mismanaging its political catch-up process, exposing the economy to increased risk of an unnecessary Fed-induced slowdown. As I have argued in previous columns, such a political error – if it materialized – would add to the woes of an economy in which the most vulnerable segments of the population already have to contend with burgeoning inflation. strongly their income. , and where too many Americans have been excluded from the housing market.
All of this is particularly unfortunate and was completely preventable.
For months, companies and other bottom-up indicators have been signaling inflation that is higher and more persistent than the Fed expected. At the same time, several measures of inflation expectations were flashing yellow, ranging from upward movements in survey data (including from the Federal Reserve Bank of New York) to multiple signs of strengthening wage negotiations. And although market-based measures remained rather contained, they were among many indicators that have been skewed by the Fed’s long period of direct intervention in the functioning of markets.
Powell now faces a more complex communications and policy challenge that is in part on his own initiative. They have major implications for the livelihoods, not only of people in the United States but around the world. Meanwhile, markets will need to start adjusting to the gradual emergence of a different liquidity paradigm that no longer automatically benefits from the Fed’s massive asset purchases.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic advisor at Allianz SE, the parent company of Pimco, where he was CEO and co-CIO; and president of Gramercy Fund Management. His books include The only game in town and When markets collide.
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