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El-Erian: Investors Expect More ‘Collateral Damage’ From Fed Moves

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What You Need to Know

  • The Fed's recent policy moves resemble behavior found in developing countries, Mohamed El-Erian wrote.
  • The Fed has damaged its credibility and must act to contain the harmful consequences, he wrote.
  • But forgoing further rate hikes could cause its own problems, he warns.

Economist Mohamed El-Erian likened the Federal Reserve’s recent policy moves to behavior typically seen in developing countries and suggested investors expect more “collateral damage” from the central bank’s aggressive monetary tightening stance.

The Fed has damaged its credibility and must act to contain the harmful consequences, the Allianz chief economic advisor said Wednesday in an opinion piece on Project Syndicate.

“Financial markets’ reaction to the U.S. Federal Reserve’s latest policy move was reminiscent more of developing countries than of the world’s most powerful economy,” El-Erian wrote.

“Given that the Fed is the world’s most systemically important central bank, this is more than just a curiosity. It has implications for America’s economic well-being — and that of the rest of the world,” he added.

El-Erian’s commentary came as stocks fell sharply this week after Fed officials dug their heels into plans to keep raising interest rates to subdue high inflation.

He noted the Fed recently reemphasized its policy on “pushing interest rates higher, faster, and for a longer duration than previously anticipated,” implementing “an unprecedented third successive 75-basis-point rate increase” and signaling it would add another 125 basis points this year.

“The Fed’s revision of its economic projections painted a darkening picture for the United States and most other economies. It is forecasting not only lower growth but also, and more surprisingly, higher inflation — something that it has done repeatedly in recent quarters,” he wrote.

“The Fed’s latest moves are consistent with a central bank that is continuously scrambling to catch up with realities on the ground,” El-Erian added. “It is the kind of thing that one typically finds in developing countries with weak institutions, not in the issuer of the world’s reserve currency and the custodian of the world’s most sophisticated financial markets — where many other countries and companies entrust their savings.”

Further, recent turmoil implies markets see the Fed struggling to catch up with investor expectations and what it needs to do to contain inflationary pressures, he said.

“Markets see a central bank that expects to cause more collateral damage as it tries to meet its inflation target,” El-Erian wrote, noting that Fed Chairman Jerome Powell recently indicated lower confidence in the likelihood of a “soft landing” for the U.S. economy as the Fed pursues higher interest rates.

“Powell has now repeatedly signaled more ‘pain’ ahead, implying an uncomfortably high probability of recession,” the economist added. ”The market appears to agree with this outlook.”

Market signals, notably the inverted yield curve on two-year and 10-year U.S. Treasury bonds, indicate the economy “lacks both a monetary-policy anchor and a sufficiently credible central bank,” El-Erian wrote.

The U.S. therefore needs more monetary tightening than it would have if the Fed had reacted to inflation “in a timely and credible fashion,” which will produce pain in foregone growth and in higher unemployment, “which will hit the most vulnerable segments of society the hardest,” he said.

The Fed, facing criticism that it’s pushing the economy into a recession, driving instability and wrecking wealth, may be tempted to forgo further rate hikes, but that could bring problems as well, El-Erian said. The bank instead should contain the consequences of its policy error by engaging in innovative thinking about its policy framework and collaborating more with other policymakers, he said.

“Sadly, it is too late to avoid all the detrimental economic and social consequences of the damage the Fed has caused to its own credibility,” he concluded. ”The central bank was notably late with its response to inflation. But it is not too late to contain the harm. Doing so is crucial.”


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