BackThe US Fed should go beyond just doubling its QE taper rate
America’s central bank should not worsen past errors on inflation
PremiumAfter the hot inflation numbers out of the US last week, it would be inadvisable and unfortunate if the US Federal Reserve were to resist at its policy meeting this week what have become broad-based calls for it to double the rate at which it is tapering its monthly bond purchases. In fact, the Fed should go well beyond that.
Sadly, the rather shocking consumer price index report for November was not an exception. It reaffirmed other data pointing to an inflation process that is stronger and more persistent than the Fed thought.
Annual inflation rose to 6.8% from 6.2%, a level not seen since 1982 in the midst of the Paul Volcker era at the central bank. The core measure of inflation, which is supposed to exclude the more historically volatile components—even though their impact on the most vulnerable segments of the population is particularly harmful—rose to 4.9% from 4.6%, also the highest for several decades.
Having failed to foresee this year’s surge in inflation and resisting repeatedly to sufficiently adjust their thinking based on updated and persuasive information, the few remaining inflation apologists on Friday still seem inclined to cling to the idea of “transitory" drivers to play down an already damaging price shock. In doing so, they fail to recall the rising probability of two phenomena that are uncomfortably familiar to those who either experienced or studied past bouts of high inflation:
First, the question is not whether some of the more powerful drivers of inflation will lose their potency; they certainly will. It is whether this happens after they plant the seeds for a broader inflation dynamic, which they are already doing.
Second, the question is not whether this broader inflation dynamic will eventually reverse; it will. Rather, it is about limiting the damage that occurs during and after such a reversal.
Historically, as the world’s most powerful central bank, the Fed has been at the centre of both these questions, with consequential domestic and international effects. By failing to demonstrate a credible understanding of inflation and acting accordingly in a timely fashion, the Fed can itself be the cause of unanchored inflationary expectations. This creates a dynamic that is much more powerful and problematic than the original catalyst for inflation, which, in this case, is a sudden deficiency of aggregate supply because of supply chain disruptions and labour shortages. As inflation rises higher and more durable than it would have been otherwise, the danger increases not just of an unnecessary economic slowdown but also an outright recession. Historically, this has been the result of the Fed having to slam on the policy brakes in a late and disorderly attempt to regain control of its credibility and its inflation mandate.
All this undermines livelihood in two unnecessary ways, both of which hit the poor particularly hard: first, by eroding purchasing power, especially for those who can least afford it, and second, by causing unemployment.
The US Fed is already seriously lagging developments on the ground and associated policy imperatives. It should have, as I have argued for months now, moved much earlier to ease its foot off the ‘pedal-to-the-metal’ accelerator by curbing bond purchases in the late spring and early summer. Instead, it simply kept repeating the mantra that inflation was transitory and, in the process, undermined the steps taken by the Joe Biden administration to curb inflation.
Fortunately, the US central bank still has a window, albeit small and shrinking fast, to act in an orderly fashion that minimizes undue damage to livelihoods. This would require it to go beyond the current consensus policy call in three ways this week:
Be honest and transparent about why it got its inflation call so wrong (what I characterized a few months ago as one of the Fed’s worst inflation calls ever, and one that risks a significant policy mistake).
Go beyond a doubling of the amount by which it reduces monthly asset purchases.
Rather than just another statement emphasizing that a bond-purchase taper does not signal anything about future rate increases, acknowledge the possibility that it may have to raise rates soon after it ends quantitative easing.
The Fed has a simple choice this week. It can either continue with its gross mishandling of inflation, or, instead start regaining credibility and its control of the narrative on inflation and monetary policy.
If the US Fed opts for the former, its institutional standing will be hit even harder, making its policy effectiveness more elusive in future; the livelihoods of many will suffer unduly; the already worrisome inequality trifecta of income, wealth and opportunity will worsen, and its internal divisions will widen.
Mohamed A. El-Erian is president of Queens’ College, Cambridge University and serves as part-time chief economic advisor at Allianz
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