Market-Fed alignment is welcome, but not enough

By Mohamed A El-Erian

For the first time in quite a while, there is an alignment between what the Federal Reserve is signaling about its interest-rate setting this year and what the markets think will happen. More importantly, this has occurred without major disruptions to the economy and markets. Yet, underpinning it all, is an assumption about policy behavior that has neither been fully endorsed by the Fed nor sufficiently internalized by markets.

After diverging quite substantially for an unusually long time, markets have adjusted their implicit pricing for 2024 Federal Reserve rate cuts from the six to seven they expected at the end of last year to just two to three on the eve of this week’s policy meeting. This expectation is consistent with what the Fed has been flagging and is likely to be validated by the “dot plot” that will be published after Wednesday’s gathering.

This market-Fed alignment, which has entailed higher market yields across maturities, has occurred with remarkably little damage to stocks and the economy. The major US equity indices are still hovering around all-time highs. The economy, while showing some areas of slight weakness, remains robust overall. It’s performing significantly better than most other advanced countries and, compared to a year ago, very few expect it to fall into recession any time soon.

All this makes sense, provided it is accompanied by a nuanced understanding of what the Fed will be willing to do (and, in my opinion, should do for overall economic well-being).

It has become increasingly clear in recent weeks that the Fed faces challenges in the “last mile” to attaining its 2 per cent inflation target. The first stage of this journey saw headline CPI inflation, the measure most widely followed by the general population, drop from over 9 per cent in June 2022 to just above 3 per cent in recent months. It was driven not just by lower price increases but also outright falls in goods that overwhelmed stubbornness in services. Also, with energy deflation playing an important role, the decline in core CPI inflation was more timid.

The last few months, however, have seen inflation stabilize rather than fall further. Indeed, the headline rate edged slightly higher to 3.2 per cent for February while core came in at 3.8 per cent. The reason for this — that is, less moderate goods disinflation and still stubborn services inflation — is expected to persist in the months ahead. It reflects a larger multi-year macroeconomic phenomenon that I have been writing about for a while: The global economy’s secular operating paradigm has shifted from a world of insufficient aggregate demand to one in which the major constraint is an insufficiently flexible supply side.

There are many reasons for this. They include the geopolitically-driven fragmentation of the global economy, the corporate shift of emphasis in supply chain management from efficiency to also include more forceful resilience, the functioning of some domestic labor markets, and the need for an energy transition. These factors will remain in play for some time, raising important issues for both businesses and policymakers including the Fed, where getting to its 2 per cent inflation target quickly may not be the best approach when judged in terms of overall economic well-being.

Given that the Fed has missed its mark badly for so long, the tolerance of higher-than-target inflation would not be done via an explicit change higher. Instead, in continuing to promise the eventual attainment of 2 per cent, the Fed would de facto tolerate a rate nearer to 3 per cent for now and look for what the Harvard economist Jason Furman calls “opportunistic disinflation.” This would allow for inflationary expectations to remain anchored while avoiding undue harm to economic growth.

We should welcome the fact that the long-awaited alignment of market and Fed anticipation for policy rates in 2024 has occurred without damaging the economy and stock markets. For this to persist, Fed policy will have to incorporate more fully what is likely to prove a multi-year shift in the global macroeconomic environment. If it doesn’t, and instead aims to get to 2 per cent inflation too quickly, both parties will end up being proven wrong about the two to three rate cuts; and the economy will fall into an unnecessary and otherwise-avoidable recession.