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El-Erian: Fed Will Punt on Economy, Inflation and Asset Prices

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What You Need to Know

  • It will likely say it's time to “start thinking about thinking about” tapering the $120 billion monthly asset-purchase program.
  • The central bank’s monthly purchases of $40 billion of mortgage-backed securities will continue pricing people out of the housing market.
  • Inflationary pressures will develop deeper roots, threatening both the length of the economic recovery and the Biden administration’s transformational economic agenda.

With few expecting the Federal Reserve to begin tapering when it announces the outcome of its latest policy deliberations on Wednesday, the focus of economists and market participants will be not only on hints of when and how such a taper may come but also on the challenges Chair Jerome Powell is likely to face in maintaining harmony within an increasingly divided Federal Open Market Committee.

The outcome of both will depend on specifics related to the economy, inflation and asset prices.

A new Covid-related cloud has settled over U.S. economic growth prospects. Its cause is the delta variant which, as in many other countries, is proving much more infectious than other iterations, especially among the unvaccinated population.

Fortunately, and consistent with the experience of the U.K., which has tended to lead the U.S. on Covid issues by four to eight weeks, the notable rise in Covid cases is not being accompanied by a sharp increase in hospitalizations and deaths, though the risk of long Covid is a concern.

Fed officials will need to decide on the extent to which this new Covid cloud undermines what had been encouraging and often-repeated upward revisions in their growth projections.

The focus will be on the service sector and involves both demand and supply dimensions: namely, the extent to which consumers may hold back their recovering engagement in travel, leisure and hospitality in particular; and the extent to which labor force participation remains below what is desirable.

Data Debate

The Fed’s inflation discussion will take place against the backdrop of more data points that suggest parts of the significant increase in the whole range of price indicators — the consumer index, the producer price index and the personal consumption expenditures price index, or PCE, the Fed’s favorite measure — may not be as “transitory” as the top-level conviction has been signaling again and again.

It may force a more focused internal discussion on what exactly transitory means and, even trickier, whether the central bank should share more operational details with markets.

Unfortunately, the analysis may continue to rely excessively on models, whose efficacy is inadvertently weakened by continuing structural changes in the economy and financial market distortions, instead of comprehensive company-based information on cost developments and pricing behavior.

Then there is the extent to which the continuous rise in asset prices is encouraging excessive risk-taking, bubbles and unsettling future financial volatility. As has been routine now, the FOMC will be meeting on the heels of yet another set of records in a host of financial metrics, including stock prices, liability-related corporate activities, margin debt, retail sector participation and more.

And even though these have not been as troubling as the time the repo rate exploded under the Fed’s nose to above 9% and required yet another set of emergency interventions, central bankers have had further reminders — this time from the bond market — that their usual dashboard no longer captures well the underlying state of market functioning.

More Fed Forecasts

I suspect that, when judged by its statement on Wednesday and the press conference that follows, the Fed will punt on all three issues.

Specifically, it will welcome the further strengthening of the U.S. economy but also acknowledge the higher Covid-related uncertainties; repeat the conviction on transitory inflation but not provide analytical backing or additional specificity; and note the elevated asset prices but refrain from drawing any conclusions about the need to step up countermeasures, especially as it relates to financial system stability.

The Fed will most likely continue to convey patience, including tolerance for inflation to run hotter and for longer than previously anticipated. It will indicate that the time has come for the FOMC to “start thinking about thinking about” tapering the $120 billion monthly asset-purchase program, noting that details on the how and when will come later and will be well telegraphed to avoid the repeat of the 2013 taper tantrum and the market instability at the end of 2018.

While markets wait for further specificity, either at the Jackson Hole symposium in late August or the September Fed meeting, the central bank will most likely continue to disconnect asset prices even more from fundamentals.

Investors will venture further afield for additional returns. Wealth inequality will worsen more.

The central bank’s monthly purchases of $40 billion of mortgage-backed securities will continue pricing people out of the housing market. Inflationary pressures will develop deeper roots, threatening both the length of the economic recovery and the Biden administration’s transformational economic agenda.

Problems of Postponement

And all this will take place without any convincing evidence that the continued adherence to the emergency monetary policies adopted just over a year ago amid an economic “sudden stop” are supportive of high, inclusive and sustainable growth.

Because of that reality, the minutes of this week’s FOMC meeting — which will be released next month — are likely to signal more disagreement among FOMC members than Wednesday’s statement and press conference will.

It will confirm that Christine Lagarde, the president of the European Central Bank, is not the only central bank governor facing mounting challenges in maintaining a unified front within the policy-making committees of systemically important central banks.

Powell is in the same boat but may have a trickier balancing act. Relative to Europe, the U.S. economy is doing better, fiscal policy is more expansionary, household balance sheets have been boosted more, asset markets have been outperforming, and the worsening in inequality has been more pronounced.

But the longer the Fed puts off its tapering decision, the greater the chance of future financial instability and unfavorable spillover into the broader economy that undermines the recovery and the economy’s beneficial transformations.

(Photo: Giulio Napolitano/Bloomberg)

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