On Marketplace, El-Erian Describes the Cost of A Late Start to Fighting Inflation

Mohamed El-Erian earned kudos on these pages when he pushed against 2021’s conventional wisdom of “transitory inflation” and insisted that the Fed needed to act to fight inflation. When too many thought that inflation would take care of itself and presented no threat to the economy, El-Erian was a solid inflation-fighting voice. So when he recently showed up to Marketplace for an interview, my ears naturally perked up.

El-Erian made several references to the tardiness of the Fed’s monetary tightening. Woven together, these quotes provide a key tenet of Fed critique and characterize the implications of being late to tightening.

“We know that, had they [the Federal Reserve] not fallen into this cognitive trap of inflation being transitory, had they acted earlier, they could have hiked into a growing economy. And they could have avoided what is one of the most front-loaded hiking cycles in history…

If you are late — and the Fed has been very late — you have no choice but to move really quickly. To make it specific, this Fed has increased interest rates by .75% four times in a row. That is a record that is almost unheard of, including during the ’70s and ’80s, when we had a much bigger inflation problem…

Even when they recognized, at the end of November last year, that inflation was not transitory, they didn’t move fast enough.”

I call the “cognitive trap” the earlier lethargy of deflationary thinking. The Fed fought and worried about deflation for so long that simple inertia nearly guaranteed the Fed would be slow to respond when real inflationary pressures appeared. Now the Fed is counting on a strong jobs market to provide political and economic cover for their mad scramble to catch up. I have yet to see anyone come to this conclusion as I have, but the proof could come in the Fed’s response to definitive evidence of a contraction in the jobs market. If the Fed is not done hiking by then, they will most likely stop hiking soon after the negative impact on the job market is obvious.

Kai Ryssdal thinks Powell admitted the Fed “blew it” in his May interview with Powell. I heard something different. The relevant quote from this interview tells me that Powell only acknowledged a small possibility that moving earlier would have generated better outcomes. However, the point is moot since the Fed would have only moved earlier with perfect information:

“I have said, and I will say again that, you know, if you had perfect hindsight you’d go back and it probably would have been better for us to have raised rates a little sooner. I’m not sure how much difference it would have made, but we have to make decisions in real time, based on what we know then, and we did the best we could. Now, we see the picture clearly and we’re determined to use our tools to get us back to price stability.”

I contend that if the Fed had implemented its risk management framework last year, that policy would have moved the Fed to start hiking rates sooner. Risk management calculations could have informed the Fed that even with the low risk assigned to being wrong about “transitory”, the cost of being wrong was great enough to make earlier rate hikes worthwhile.

Sticky Inflation

Six months ago, I referenced the concept of “persistently elevated, unactionable inflation.” El-Erian talked about the potential for sticky inflation. He described the possibility this way: “…because the Fed waited for so long, the inflation challenge has shifted from the interest rate-sensitive sectors to sectors that are less interest rate-sensitive: services and wages.” Assuming El-Erian is correct, then as the economy grinds into a slowdown next year, the Fed is likely to concede to an economy with inflation above target. El-Erian makes the following supportive claim:

“…if they were formulating the inflation target today, I doubt it will be 2%. I think most people agree it would be higher than that…So the best we can hope for is, by the middle of next year, we’ve gotten to stable inflation of about 3% to 4%. They keep on telling us that they’re gonna pursue 2% in the future, and society learns to live with a stable inflation rate that is not 2%.”

Considering what the economy has experienced for almost three years, some stability might feel like a welcome change.

Before careful out there! (I highly recommend reading or listening to the full interview with El-Erian)

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