Markets are pushing Fed into developing-economy territory

The Fed risks slipping further into a no-win interaction with markets that is more familiar to developing countries than to a systemically important central bank — let alone the world’s most powerful one.

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:

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.

Despite ample evidence to the contrary starting almost a year ago, the Fed stuck to its “transitory” characterization of inflation until the end of November — what I called months earlier one of the worse inflation calls in the history of the Fed. Even after it belatedly “retired” the word from its vocabulary, the Fed kept its foot on the accelerator of policy stimulus. To illustrate the extent to which its policies remained misaligned, it was still injecting liquidity through its asset purchases earlier this month, including the week in which the February reading for U.S. inflation came at 7.9 per cent.