Although it has now established more consistent messaging to the market, the U.S. Federal Reserve needs to do two more things to re-establish its credibility, according to Mohamed El-Erian, chief economic advisor to Allianz.
Fed Chairman Jerome Powell struck a hawkish tone during his speech at the Jackson Hole economic symposium last week, reinforcing the central bank’s commitment to aggressive monetary policy tightening in order to rein in inflation, and warning that the U.S. economy will face “some pain” in the process.
Prior to establishing a firm message in recent months — with inflation running at a 40-year high — Powell and other Fed officials had struggled to guide markets effectively, after accepting fault for inaccurate projections throughout 2021 that inflation would be “transitory.”
“The more Fed officials repeat it, the more the market is pricing it in, but it’s mainly the fixed income markets so far that have priced it in,” El-Erian told CNBC’s Steve Sedgwick at the Ambrosetti Forum on Friday.
“Other markets are hoping somehow that we are in a cyclical moment, not in what I think is more secular and strategic.”
El-Erian gave the Fed credit for establishing a clear and consistent message, but said it would need to do two more things in order to give its forward guidance credibility from here on out.
“One is to explain to the marketplace why it got its analysis so wrong and what has it done about its forecasting abilities,” he said.
“And secondly, change its framework. Remember, we still have a framework that is for a world of deficient aggregate demand and we’re in a world of deficient aggregate supply.”
El-Erian added that the current framework has been geared toward an environment in which inflation has been “too low for too long” and where it is expected to remain low for a long period of time. He suggested that the central bank needs a new framework entirely.
“That was the world before the pandemic. This framework was introduced in 2021, but unfortunately it’s backward-looking, so we do need a new framework, and I don’t think people quite realize how important the governing framework is,” he said.
“That’s why, when I look at the Fed, I say they’ve done great on one thing but there’s two more things they need to do if their forward policy guidance is to stick.”
Until inflation began soaring to 40-year highs, El-Erian said the market had “held the Fed hostage for a long time,” deducing what it wanted from policymakers’ mixed messaging on the pace and scale of monetary policy tightening.
“Once you bring in an inflation rate of 8.5% suddenly the ability of the market to hold the Fed hostage dissipates. I think that’s what the market is starting to realize — this is not the old days, inflation has fundamentally changed the equation,” he said.