These two missteps have resulted in persistently high inflation that, at 8.6 per cent in May, is hindering economic activity, imposing a particularly heavy burden on the most vulnerable segments of the population, and has contributed to significant market losses on both stocks and government bonds. Now a third misstep may be in the making as indicated by developments last week.

Recession risks

Having rightly worried about the Fed both underestimating the threat of inflation and failing to evolve its policy stance in a timely manner, markets now feel that a late central bank scrambling to play catch-up risks sending the US economy into recession.

This contributed to sharply lower yields on government bonds last week just as Fed chairman Jay Powell appeared in Congress with the newly found conviction that the battle against inflation is “unconditional”.

The markets are right to worry about a higher risk of recession. While the US labour market remains strong, consumer sentiment has been falling. With indicators of business confidence also turning down there is growing doubt about the ability of the private sector to power the US economy through the big uncertainties caused by this phase of high inflation.

Other drivers of demand are also under threat. The fiscal policy impetus has shifted from an expansionary to contractionary stance and exports are battling a weakening global economy. With all this, it is not hard to see why so many worry about another Fed misstep tipping the economy into a recession.

In addition to undermining socio-economic wellbeing and fuelling unsettling financial instability, such a misstep would erode the institutional credibility that is so crucial for future policy effectiveness. And it is not as if Fed credibility has not been damaged already.

In addition to lagging behind economic developments, the central bank has been repeatedly criticised for its forecasts for inflation and employment – the two components of its dual mandate. A recent illustration of this was the sceptical reaction to the Fed’s update on monetary policy released on June 15.

The scenario that worries the market – the Fed aggressively lifting rates only to be forced to reverse by the end of this year because of the threat of recession – is certainly a possibility, and it is not a comforting one.

There is another equally possible alternative, if not more likely and more damaging economically and socially: a multi-round, flip-flopping Fed.

In this scenario, a Fed lacking credibility and sound forecasts would fall in the classic “stop-go” trap that haunted many western central banks in the 1970s and 1980s and remains a problem for some developing countries today lacking policy conviction and commitment.

This is a world in which policy measures are whipsawed, seemingly alternating between targeting lower inflation and higher growth, but with little success on either. It is a world in which the US enters 2023 with both problems fuelling more disruption to economic prosperity and higher inequality.

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy.

Financial Times