• Currency watchdogs risk a recession
• Mohamed El-Erian thinks the 2 percent inflation target is too low
More than a year ago – i.e. when the US monetary authorities were still dismissing the growing inflationary pressure as a temporary phenomenon – the Egyptian-US American economist Mohamed Aly El-Erian warned that the US Federal Reserve was not fighting the risk of inflation with enough determination and that it later to intervene so harshly that it risks a recession. With this forecast he should be right. Rising inflation in the USA continued to increase due to the Ukraine war and global supply chain problems and even reached its highest level in over 40 years in June 2022.
In the meantime, the Fed has recognized its mistake and responded with an unprecedented series of large rate hikes. Most recently, in mid-December, the US monetary authorities raised the key interest rate by a further 50 basis points to between 4.25 and 4.50 percent. The Fed has also signaled that the 2023 rate peak of around 5.1% is likely to be higher than projected at around 4.60% in September, and has firmly dismissed the notion that it could cut rates again as early as next year . However, this is hawkish monetary policy also a balancing act for the central bank, because higher interest rates help to dampen inflation, but can also slow down economic growth. As a result, fears of a recession are now increasing again among many market participants.
Mohamed El-Erian is probably one of the Fed’s most prominent critics: “The Fed is still trying to catch up to rein in rising prices after its long-running huge misjudgment last year that inflation was only temporary and after its initially very hesitant steps to withdraw monetary stimulus,” wrote the president of Queens’ College, Cambridge University, in a recent article for the Financial Times.
Mohamed El-Erian criticizes the Fed’s inflation target
The criticism of the prominent economist, who was formerly CEO of PIMCO, is now mainly directed at the Fed’s declared inflation target. In August 2020, in the middle of the corona crisis, the US Federal Reserve switched its monetary policy strategy to a “flexible form of an average inflation target”. In this way, the Fed has given itself more room for monetary policy by deciding that the future inflation target should only average two percent. According to this new model called “Average Inflation Targeting”, the inflation rate can now be kept above the 2 percent target for some time if it was previously below this targeted ideal value for some time. The fact that past inflation is taken into account is new, before that there was only a forward-looking target.
But although the monetary authorities now have more leeway, Mohamed El-Erian criticizes the target of 2.0 percent. He does not consider this level to be the ideal inflation level. According to the economist, next year, 2023, the Fed will face a tough choice: either destroy economic growth and jobs to meet its 2 percent target, or publicly set a higher inflation target, risking a new round of destabilized inflationary expectations .
In view of unstable supply chains, the shift away from fossil fuels and the long period of ultra-loose monetary policy, the economist, who expects inflation to remain stubborn in 2023 and stay above the 2% target, holds an inflation target of three to four percent for more appropriate. In his view, it is possible that the monetary authorities are officially sticking to their 2 percent target, but are actually secretly aiming for a higher number and hope that the public will accept this. While doing so would risk casting doubt on the Fed’s reliability, El-Erian says the Fed may still see it as the best course of action given the uncertain circumstances.
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