Mohamed A. El-Erian is president of Queens’ College at Cambridge University, a professor at the University of Pennsylvania’s Wharton School and an adviser to Allianz and Gramercy.
The Fed, in responding to the massive economic damage caused by covid-19, moved aggressively in March 2020 to floor interest rates and inject massive amounts of cash into the system. It did even more the following month. All this came on the heels of more than a decade of ultraloose monetary policy launched during the worst of the 2008 global financial crisis.
Some 15 months after the Fed’s latest emergency intervention, the world’s most powerful central bank is still maintaining its pedal-to-the-metal stimulus. Interest rates are still floored, the balance sheet has doubled to some $8 trillion, an enormous amount of cash is sloshing around the financial system, the nation’s debt has skyrocketed and the Fed continues to inject $120 billion every month.
The main stated reasons for maintaining such exceptional emergency measures include concerns about the incomplete rebound in jobs and remaining uncertainties about the economic outlook. Both concerns are justified and important to address. Despite a record level of reported job vacancies (9.2 million), employment remains well below the pre-pandemic level just when the more infectious delta variant challenges growth prospects.
Yet an ultraloose monetary policy stance is no longer part of the desirable policy response. Continuing on this trajectory could inflict unnecessary damage on the economy in the next 12 months, fuel unsettling financial volatility, worsen already-high inequality and derail Biden’s agenda. And those avoidable risks are just the domestic component of rising threats to economic prosperity and social well-being.
There are five reasons why this might happen: First, the Fed’s policy tools are ill-suited to address what is hampering the economy. The primary problem is widespread supply-side disruptions, from dislocated supply chains and higher input costs to transportation bottlenecks and difficulties in hiring workers.
Second, with both private and public demand already surging, the Fed’s policy stance risks fueling inflation. Both the producer and consumer inflation measures (PPI and CPI) are already flashing warning signs.
Third, its continued massive intervention in markets has distorted the price signaling mechanism, encouraging all sorts of inefficient resource allocations that will eat away at the U.S. economy’s productivity and dynamism.
Fourth, the ample and predictable injection of cash into the system continues to encourage excessive risk-taking in financial markets while deepening the unhealthy conditioning among investors to always expect the Fed to boost asset prices regardless of how disconnected they are from economic and corporate fundamentals. In the process, wealth inequality worsens.
Finally, the $40 billion of mortgages that the Fed insists on buying each month is contributing to a red-hot housing market that has been pricing out more and more Americans.
If the Fed maintains its current policy stance, it risks inadvertently creating a perfect storm for the U.S. economy later this year and early next year: a combination of high inflation, slowing growth and financial instability. This would come with political and social consequences that could further undermine the much-needed economic recovery and expose the most vulnerable segments of our population to more pain. And it would take hold at a moment when, due to persistently high inflation, the Fed would feel forced to slam on the monetary policy brakes, aggravating every element of this unfortunate mix.
Concerns about inflation have already led some to call for the Biden administration to moderate its plans to invest in both physical and human infrastructure. Yet such a response would only make the problem worse.
In contrast to the current ineffectiveness of Fed policy in generating genuine economic growth, the administration’s fiscal agenda holds the key to enhancing productivity, increasing labor force participation and providing greater opportunities for advancement to more Americans. Indeed, the envisaged infrastructure measures are essential if the U.S. economy is to decisively overcome its multiplying supply-side bottlenecks and better position both its human and physical assets for a future of greater and more sustainable prosperity. To reduce the risk of financial instability, the investments need to be accompanied by enhanced financial supervision and regulation, especially with respect to non-bank market intermediaries.
It is disappointing that the Fed’s insistence on maintaining emergency measures, once needed and effective, now risks being increasingly counterproductive for the economy and fuels excessive financial risk-taking. It would be tragic if it also ended up damaging a much-needed inclusive recovery and derailing this administration’s economic agenda.