By Mohamed A. El-Erian
Markets surged on Wednesday after Jerome Powell, the Federal Reserve chair, indicated that the world’s most powerful central bank would slow the pace of rate increases this month. The fact that this remark was balanced by warnings about the uncertain outlook for inflation and policy proved irrelevant for markets. All that they heard was the good news.
This is far from comforting for a Fed that still needs the markets to help it bring down high inflation. It also does not help counter the political pressures it faces for failing to respond to inflation on a timely basis nor the risks of tipping the economy into a recession that would hit the most vulnerable segments of the population particularly hard.
By imagining the following hypothetical, tongue-in-cheek conversation between Powell and financial markets, you may get a good feel for two things: why the Fed faces, and will continue to face, a tricky communication challenge that is consequential for the well-being of the US and global economies, and why it confronts what will be an intensifying political challenge.
Powell: Did you listen to ALL that I said on Wednesday at the Brookings Institution?
Markets: We heard one thing more than anything else. You are definitely going to slow the pace of interest rate hikes starting as early as this month! You were totally unambiguous in stating that “the time for moderating the pace of rate increases may come as soon as the December meeting.” That is dynamite!
Powell: But there was so much more to what I said. I provided several warnings about what is ahead and, therefore, I pointed to interest rates going higher for longer.
Markets: Maybe. But you also mentioned that you are worried about tightening too much. You hadn’t done that for quite a while. And it is not only you. You explicitly said that it was your FOMC colleagues as well.
Powell: Not so fast. You are too one-sided. Did you hear me say that there was “more ground to cover” in fighting inflation and that history is clear about “prematurely loosening policy.”
Markets: What we noticed is that you told us you are downshifting on rate hikes before the publication of Friday’s jobs report. You obviously feel strongly about this.
Powell: Wait …
Markets: We also noticed what you failed to say. You made no attempt to push back against our massive loosening of financial conditions in recent weeks. With that, we got an even brighter green light from you to loosen them even more, driving stocks up 2% to 4% on your remarks, depreciating the dollar and lowering bond yields by some 10 basis points on average so that the 10-year Treasury is now almost 50 basis points below where it was a month ago. Surely that is what you expected! A massive loosening of financial conditions.
Powell: No. I expected you to hear the entirety of my remarks and not just what you wanted to hear.
Markets: Really? But we have been conditioned for years to expect strong support from the Fed in the form of rates and liquidity. And this is where you seem to have signaled we are starting to go back to, especially now that inflation is no longer a problem. Just look at your own projections!
Powell: Wait, wait, wait. It’s way too early to declare victory over inflation. Indeed, I explicitly said on Wednesday that we would need “substantially more evidence” before we would be comfortable that the inflation problem is behind us. I also said that our inflation forecasts have repeatedly proven wrong.
Markets: But actual and forward indicators of inflation uniformly point down, and not just in the US.
Powell: It is one thing for inflation to come down. It is another thing for it to return to our 2% target. The inflation problem is not behind us. Then there is a weakening growth outlook. Surely that matters for earnings and stock prices.
Markets: Oh, we did hear you say something about that. But you have also, at least implicitly, repeatedly reinforced the market consensus that a recession, were it to materialize, would be short and shallow. That means we should just “look through it.”
Powell: I just wish politicians would look through it, too. I don’t think they like it when I predict below-trend growth and higher unemployment. They think the Fed can somehow avoid this.
Markets: Well, we sympathize with them.
Powell: What do you mean? Surely you know that overcoming the inflation threat is crucial for high, durable and inclusive growth that is also consistent with the battle against worrisome climate change.
Markets: Yes, but wouldn’t we be in a better place on most counts had the Fed not badly and protractedly mischaracterized inflation as transitory; had the Fed tightened policy faster when it finally “retired” “transitory” from its vocabulary; and had it not been therefore forced into a record four consecutive 75-basis-point rate increases?
Powell: Sorry. It is almost time for our blackout period ahead of our December policy meeting.