RATE RISES SHOULD NOT BE "THE ONLY GAME IN TOWN" / THE FINANCIAL TIMES MARKETS INSIGHT

Rate rises should not be ‘the only game in town’

Monetary policy is not the best response tool for today’s economic and financial challenges

Mohamed El-Erian

While inflation has run above the Fed’s target for over five years, its underlying drivers have kept evolving © Michael Nagle/Bloomberg

After the Federal Reserve validated overwhelming expectations by raising rates last week, markets immediately shifted to a more hawkish stance, pricing in three additional increases by mid-next year.

Such a tightening bias is also evident in what investors expect for other major central banks, including the Bank of England, even though it was the only one of its peers not to raise rates in September. 

Yet if all this comes to pass, both markets and the economy could end up in a bad place for a simple reason: monetary policy isn’t the best response tool for today’s economic and financial challenges.

That is despite the more hawkish path being welcomed by those investors and economists narrowly focused on inflation, which has been ticking up across advanced economies because of higher energy prices. 

As central banks do not have a direct influence on those costs, the calls have mounted for them to use their primary policy lever to damp demand. 

This in turn lowers the risk of actual inflation, keeps expectations anchored and protects institutional credibility.

Consider the US experience. 

With a more than 90 per cent likelihood of a rate rise priced into markets ahead of last week’s policy meeting, the Fed faced intense pressure to fulfil expectations even though the broader economic arguments were finely balanced.

It feels like a familiar dynamic for those who have closely followed central bank policies in recent years. 

Rather than responding strictly to underlying fundamentals, institutions have often felt constrained by an implicit contract with traders: validate market pricing or risk unsettling financial volatility. 

Fed Chair Kevin Warsh aptly called this the “hall-of-mirrors” phenomenon. It risks unnecessarily sacrificing the real economy to satisfy market pricing.

While inflation has run above the Fed’s target for over five years, its underlying drivers have kept evolving. 

What began mainly as a pandemic-era supply shortfall quickly morphed into excess demand. 

The extensive delay in launching the hiking cycle ensured stickier inflation for longer, despite the belated response becoming one of the fastest monetary policy tightening campaigns in US history.

As indicators of excess demand eventually cooled, the Fed and other central banks felt comfortable pausing rate rises. 

However, the subsequent pivot towards cuts was slowed by the persistent inflation pressures and then derailed by another energy price shock following the Iran war. 

As headline inflation rose, central banks have felt compelled to initiate a hiking cycle that markets are now braced for.

The uncomfortable historical analogy here is what many view as the European Central Bank’s 2008 policy mis-step: tightening monetary policy right on the cusp of economic softening. 

However, if a downturn were to occur now, it is unlikely to stem from severe banking system dislocations and deleveraging that pull the rug from under the economy. 

Instead, it would come from interest rate-sensitive sectors, such as housing and autos, and among low-income consumers.

Crucially, the most effective remedies for today’s inflationary pressures do not lie with central banks. 

Instead, they lie with other policymakers. 

What’s needed on the supply side is to reduce the sensitivity of economies to multiplying choke points like the Strait of Hormuz, either through the direct lifting of maritime disruptions or a larger number of ways around them.

On the demand side, fiscal consolidation to reduce debt burdens and budget deficits is required. 

This would also have the advantage of freeing up bond-market capacity for the ongoing huge issuance of tech companies building out AI infrastructure. 

As a result, central banks would face less market pressure to raise rates in order to reinforce institutional credibility and contain inflation expectations to ease longer-term yields.

Without more timely supply-side and fiscal actions, central banks risk being sucked back into the uncomfortable position of being “the only game in town”. 

The experience after 2008 in particular suggests that this can push central banks outside their lane, distort resource allocation across the economy, encourage excessive risk-taking and erode policy effectiveness.

Ultimately, if the focus stays on monetary policy, the economy risks stumbling into an unnecessary weakening that places a disproportionate burden on those who can least afford it. 

This would ill serve the economy and the health of markets. 

It would also erode policy credibility and central banks’ reputations. 

What is needed is less in the hands of central banks and more in the hands of governments.

The writer is the Rene M Kern professor of practice at Wharton School, chief economic adviser at Allianz and chair of Gramercy Funds Management