The writer is president of Queens’ College, Cambridge university and adviser to Allianz and Gramercy
The US Federal Reserve monetary policy meeting this week has turned from a snooze-fest into a test of the institution’s control of the narrative it sought to promote in markets: that the current spike in inflation is transitory.
How the Fed responds has implications not only for its policy credibility but also for President Joe Biden’s economic reforms and global financial stability.
Developments on the ground have pinned the Fed into a corner of its own making as a stronger economy challenges the central bank’s commitment not to tighten policy until there is actual evidence, rather than forecasts, that employment and inflation are at target levels — its so-called outcomes-based policy framework.
While longer term uncertainties remain, there is now greater clarity about this year’s US recovery.
Demand is on a sharp upswing with significantly higher public and private consumption accompanied by a pick-up in corporate investment and manufacturing exports. The supply side is responding, but insufficiently so.
This has resulted in widespread supply bottlenecks, inventory problems, and transportation challenges. Meanwhile, significant demand to hire new employees is being frustrated by too few workers able and willing to fill what are now record job openings.
Some of these trends are temporary and should be reversed soon. Others are not, with high likelihood that notable wage and price rises will stick.
Last week’s US data included, once again, hotter than expected inflation with an increase of 5 per cent for the headline measure and 3.8 per cent for core. They confirmed an upward inflationary trend that is a lot faster than many expected.
Yet yields on US government bonds fell sharply despite growing concerns about the scale and scope of such inflationary pressures.
This price action has pushed some to suggest the Fed should take comfort in the markets’ agreement with the central bank’s narrative on current price rises being transitory. While there may be some merit to this view, it would be unwise to give it much weight.
One of the loud messages of the past few years is that unconventional central bank policies can notably and durably repress yields and distort market signals. They do so in two ways.
First, ample and predictable central bank purchasing of securities provide reassurance for many that the downward pressure on yields will persist, especially when central banks demonstrate they are willing non-commercial buyers (ie insensitive to rich valuations). Second, floored policy rates encourage investors to opt for longer dated debt in search of extra yield.
These two effects are amplified when central banks continue to back their actions with the regular reiteration of ultra-loose forward policy guidance.
For the Fed, this has involved three factors: repeating that it’s “not thinking about thinking” about any tapering of asset purchases; an unusually long forward commitment to zero rates; and the shift to an outcome-based monetary framework.
All three serve to extend market expectations of ultra-loose financial conditions regardless of economic realities.
This disconnected liquidity paradigm is good news for stock investors and for holders and issuers of corporate and emerging market bonds. In the process, it encourages the continued migration to ever more risky opportunities.
But it also comes with considerable risks. Indeed, a lot more is riding on the Fed’s judgment — more like faith — that the surge in US inflation will indeed prove transitory. And the threats go well beyond the institutional credibility that is so critical to the effectiveness of Fed policy.
It risks a sudden slamming of the monetary policy brakes, thereby increasing the possibility of a recession. Unsettling financial volatility down the road is more likely, another potential headwind to the much-needed period of high and sustainable growth.
And it results in an unbalanced policy mix that could undermine the Biden administration’s economic and social reforms that aim to enhance inclusive prosperity and productivity.
It would be wrong to reduce the markets’ reaction to inflation risks to a sign of a relaxed approach to the underlying dynamics. Instead, it reflects a grudging respect for the ability of a conviction-driven Fed to distort prices for a considerable period of time. What is risked thereafter, however, should give us all pause to be more humble and open-minded about the nature of inflation.