While the market chatter in the run-up to Wednesday’s Federal Reserve interest rate decision has understandably focused on whether the increase will be 50 or 75 basis points, the critical issue in play is a broader one. For its sake and that of both the domestic and global economy, the central bank desperately needs to regain control of the inflation narrative.
The persistent failure to do so in the past 12 months is turning the perception of the Fed from the world’s most powerful central bank—long respected for its ability to anchor global financial stability—to an institution that too closely resembles an emerging-market bank that lacks credibility and inadvertently contributes to undue financial volatility. Regaining control of the inflation narrative is critical to the Fed’s policy effectiveness, its reputation and its political independence. The longer this takes, the greater the negative effects on economic well-being and social equity in the U.S., and the larger the negative spillovers for the rest of the world.
The evidence of the Fed’s loss of control has multiplied uncomfortably in recent weeks.
Once again, its forecasts for inflation, one of its dual mandates, have been off. Meanwhile, longer-term inflationary expectations have deviated further from the Fed’s 2% target, with the University of Michigan’s measure for the next five to 10 years reaching a multidecade high of 3.3%. With that, even the part of the market on which the Fed has the most influence, typified by the two-year Treasury note yield, has been subject to eye-popping large and disorderly moves up that are frightening for one of the most critical segments of global financial markets.
Just as worrisome is the Fed’s misplayed attempt at precision. Its signaling of two 50-basis-point increases a few weeks ago first led markets to contemplate a September pause in the rate cycle. That thinking was then firmly displaced by speculation about an immediate 75-basis-point increase on a journey to a terminal rate well above anything mentioned by the Fed.
That caused yet more undue volatility in markets; and with that comes greater distancing for the Fed from the “first best” policy response and a deepening of a lose-lose policy dilemma that is largely of its own creation—that is, slam on the policy brakes to fight inflation at the cost of a consequential risk of recession or tap the brakes more gently and risk persistently high inflation well into 2023.
The notion of a central bank consistently chasing inflationary developments, running out of good policy options and, in the process, intensifying economic and financial volatility would not be uncommon in a developing country lacking institutional credibility and maturity. It is highly unusual, and particularly distressing, for the central bank that is at the center of the international monetary system.
The result is an amplification of the adverse spillover effects for the rest of the world, putting at considerable risk financial stability in some of the countries at the periphery of the global system. At home, it undermines economic prosperity and adds to the considerable pressures already being faced by the most vulnerable segments of the population.
Fortunately, the urgency of regaining control clarifies the immediate steps that the Fed must take.
First, it needs to share its analysis of why it has repeatedly misread inflation for so long and how it has now improved its forecasting capabilities. Without this, the Fed will continue to find it difficult to convince markets that it has a handle on inflation, leading to a further de-anchoring of inflationary expectations.