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The Fed Should Think in Terms of a Trilemma

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After the Federal Reserve meets Nov. 1 and 2 this week, we may know more about how this Fed will be remembered: as a Volcker Fed that decisively conquered inflation or, instead, a Burns Fed that allowed the country to slip into a stagflationary quagmire. But this already complex reality is even more complicated. Fed Chair Jerome Powell faces a policy challenge that could well prove more challenging that that faced by his predecessors from the 1970s and 1980s: lowering inflation, avoiding undue damage to the economy and livelihoods, and avoiding a financial accident in the process.

While the market consensus for this week’s Fed policy meeting is heavily in favor of a record fourth consecutive 75-basis-point interest rate hike, views diverge significantly on what the Fed should signal about its future moves. Some think the Fed should suggest a significant slowing of the pace of rate hikes in face of a weakening economy, both domestically and internationally. This, they say, would protect growth and save jobs.

Others, given that core inflation is still going up, think that the Fed should maintain its hawkish tone by signaling the continuation of a robust hiking pace and pointing to a higher peak rate. This, they say, is what’s necessary to defeat inflation and avoid stagflation. Then there are a variety of views somewhere in between.

Contrasting the Fed as led by Arthur Burns with the Fed as led by Paul Volcker has been used as shorthand for this debate between jobs on the one hand and inflation on the other. Derived from the experience of the 1970s, the Burns Fed refers to the notion of a central bank that erroneously moderates its fight against inflation only to be later forced into a U-turn when confronted with a stagflationary mess. The Volcker Fed, derived from the events of the 1980s, refers to a central bank that is willing to tolerate significant damage to growth and jobs in order to sustainably defeat inflation. (My Bloomberg Opinion colleague Bill Dudley described well what is at stake in both cases last week.)

This week’s Fed statement and, more likely, the tone and content of the subsequent press conference may shed some partial light on which more resembles the Fed’s approach under Powell.

Yet the Powell Fed not only faces the twin challenges of battling inflation while worrying about jobs and growth, but a third problem as well: maintaining financial stability.

This third factor is not entirely new. Soon after the Fed hiked interest rates aggressively under Volcker and the US economy fell into recession, the US had to play a major role in coordinating a global response to minimize the damage from a Latin American debt crisis. As the related exposure in the US was contained in the banking system — and, within that, mainly in a handful of money-center banks — the authorities were able to use a mix of moral suasion, regulatory forbearance and financial assistance (including from the International Monetary Fund for Latin America) to avoid the problem contaminating the real economy.

Today, what’s new is where the risk of financial instability resides. Unlike in the 1980s, the fragility is not in the banks but, rather, in the less well-regulated and supervised non-bank sector that includes asset managers, pension funds, hedge funds, private equity and the like. It is mainly the result of two things: first, the extent to which non-banks were conditioned to optimize what many believed would be a quasi-permanent policy of extremely low interest rates and massive liquidity injections (so called “QE infinity”); and second, a Fed that, since June, has had to dramatically raise interest rate hikes after starting too late and too little.

Managing this financial instability risk won’t be easy. Too aggressive a rate-hiking cycle could create a financial accident that worsens the fall in growth and jobs. Too slow a cycle could maintain immediate financial stability at the cost of pushing the economy into stagflation. That would, down the road, leave inflation too high, growth struggling and financial instability still threatening.

Striking a tricky and delicate balance between stability, inflation and jobs suggests that the Fed should be thinking in terms of a trilemma and not just a dilemma.

Judging from his repeated references to Volcker in recent public remarks, Powell understandably wants to avoid any and all comparisons to Burns. For this to materialize, the Fed would need to quickly come to grips with the trilemma it is facing and, working with others, do more to design and deploy tools that allow it to handle three objectives that, currently, cannot easily be balanced.

More From Bloomberg Opinion:

• The Fed Is Giving Americans a Harsh Lesson in Lag Time: Allison Schrager

• Will Jerome Powell Be Like Volcker or Burns?: Bill Dudley

• Fed’s Slowdown Isn’t Getting Much Help from Big Tech: Conor Sen

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”

More stories like this are available on bloomberg.com/opinion

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