The Fed makes welcome pivot but has more to do

In a move labeled by some as a hawkish pivot and by others as a great reset, the Federal Reserve’s policy committee just went in one meeting from its often-repeated characterization of inflation as “transitory” to portraying it as the “No. 1 enemy” facing the economic recovery. This policy change, while seemingly abrupt and drastic, is much needed and highly welcome. That’s the good news. Less good is that it is not sufficiently bold, at least as yet, and especially because it is coming so late.

Noting that inflation is proving to be much higher and much more persistent than the central bank’s repeatedly revised upward forecasts, Chair Jerome Powell announced on Wednesday a faster rate in the reduction of its monthly asset purchases (the so-called taper). The Fed also signaled the probability of a more aggressive initial cycle of rate increases, noting that “significant progress” has been made on “maximum employment,” the other component of its mandate.

The markets’ immediate response was seemingly curious, especially to those who viewed the Fed’s pivot as more hawkish than consensus expectations. Financial conditions loosened rather than tightened. The notable surge in stocks was accompanied by some reduction in yields on government securities, a development that led one longtime reporter to argue that the markets had not heard the Fed properly.

It could well be that markets have not fully understood the Fed’s policy statements. Indeed, that is a better explanation than the narrative that markets are moving to price in the effects of a globally worsening growth outlook because of the rapid spread of the omicron variant, which is inducing more governments to tighten health-related restrictions. That would be consistent with what happened to government yields after the policy announcement but would go against the accompanying global move up in stocks.

My own take is that the markets’ reactions look a lot less curious if the Fed’s policy announcements and signals are judged not by where the Fed has come from but rather where it should be. Indeed, you need only compare those reactions with what happened on Thursday after the decision by the Bank of England — considered to have led the way among the main central banks in understanding inflation dynamics and their policy implications — to raise interest rates 15 basis points to 0.25%. U.K. 10-year yields rose while stocks pared gains.

Powell’s characterization on Wednesday of inflation and employment is at odds with maintaining a policy approach that is still incredibly expansionary. Moreover, he noted in his press conference that the Fed’s policy moves are influenced by its sensitivity to financial volatility, inadvertently reinforcing the view in markets that, if push comes to shove, the Fed will have no choice but to retain some form of the monetary policy “put” that has proved so remunerative for investors.

Through its continued great aversion to market volatility, the Fed risks making the policy transition even more challenging in two main ways. It also risks unduly damaging livelihoods. Indeed, this could well still be the baseline, unfortunately.

First, the initial set of policy announcements and signals is not powerful enough to stop the change in inflation dynamics. Inflation is now being fueled not just by supply bottlenecks, particularly supply chain disruptions and labor shortages, but by the changing behaviors of both households and companies. That makes its drivers broader and more long lasting.

Second, Wednesday’s insufficiently bold policy move encourages asset prices to decouple even more from underlying fundamentals when the global growth outlook is becoming more uncertain. Just think what would happen if the rising possibility of stagflation, still a tail risk rather than in the baseline, were to be priced in by markets rather than sidelined by the Fed’s continued support and capture.

The key message to the Fed is clear. While highly welcome, the policy pivot is only a start and will need to be reinforced in the weeks ahead. Indeed, it would not surprise me if, looking at the markets’ reaction, some Fed officials may be regretting not going further this week — especially when they consider what the Bank of England did despite the U.K. facing a more uncertain growth outlook. Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is president of Queens’ College, Cambridge; chief economic adviser at Allianz, the parent company of Pimco where he served as CEO and co-CIO; and chair of Gramercy Fund Management.