Judging from price movements on Monday, the Federal Reserve risks slipping further into a no-win interaction with markets that is more familiar to developing countries that lack policy credibility than to a systemically important central bank — let alone the world’s most powerful one. Absent a quick reestablishment of its inflation credential, something that the markets doubted again on Monday, the Fed would face even more of a no-win policy paradigm that would cause what, only a few months ago, was avoidable harm to livelihoods in the U.S. and beyond.
This unfortunate sequence is painfully familiar to some developing countries:
- First, through a misdiagnosis of the economic situation or policy inertia or both, the central bank falls behind inflation realities and erodes its inflation-fighting credibility.
- Second, swallowing its pride, the central bank acknowledges that inflation is too high, toughens up its policy narrative and embarks on the needed measures.
- Third, rather than be reassured by this (albeit late) change, markets run further away from the central bank and signal the need for even more aggressive policy measures.
- Fourth, the central bank finds itself in the dilemma of either risking a recession by validating the ever-more hawkish market pricing or seeking to minimize such damage, often unsuccessfully, by enabling high and potentially more destabilizing inflation to persist even longer.
With this sequence in mind, consider what happened on Monday, less than a week after the Fed’s top policy-making committee raised interest rates by 25 basis points and signaled further increases.
In a presentation to the National Association for Business Economics, Chair Jerome Powell tried to restore the Fed’s eroded inflation-fighting credibility by signaling that the central bank is willing to increase interest rates by 50 basis points in May, repeat that at other meetings and continue raising past the neutral level in a bid to meet its inflation objective. Yet nominal market yields, the yield curve and inflation breakevens were far from reassured. Instead, they moved further away from the Fed.
While Russia’s invasion of Ukraine has amplified the Fed’s policy challenges, the hole it is in is of its own making, and that was illustrated by Monday’s developments.