El-Erian Says Fed Needs To Raise 2% Inflation Target Or It Will “Crush The Economy”

Recall back in September, when we wrote that “The “Scariest Paper Of 2022” Reveals The Terrifying Fate Of Biden’s Economy: Millions Are About To Lose Their Job” we reminded readers of what we wrote last June, when we said that “at some point Fed will concede it has no control over supply. That’s when we will start getting leaks of raising the inflation target“…

At some point Fed will concede it has no control over supply. That’s when we will start getting leaks of raising the inflation target

— zerohedge (@zerohedge) June 21, 2022

… and just a few months later that’s precisely what happened because according to a growing number of economists, such as Obama’s own top economic adviser from 2013-2017 and currently economic policy professor at Harvard, Jason Furman, “To bring price increases down to 2%, we may need to tolerate unemployment of 6.5% for two years” who added that to avoid a social crisis, “stabilizing at a 3% inflation rate is probably healthier for the economy than stabilizing at 2%—so while fighting inflation should be the central bank’s only focus today, at some point the Fed should reassess the meaning of victory in that struggle.”

(iii) Seriously consider raising the inflation target to something like 3 percent

This one is tricky. On a blank slate a 3% target would be better than a 2% target. But shifting to that could deanchor expectations.

— Jason Furman (@jasonfurman) September 8, 2022

The point Furman – a lifelong democrat – was making was simple: if the Fed’s inflation target does not rise from 2%, it would lead to (at least) a 6.5% unemployment rate in 2024 which would translate into no less than 10.8 million unemployed workers, an 80% increase from the 6 million today. Needless to say, this would be political suicide for any Democratic administration .

To be sure, there are huge implications to raising the inflation target, not least of which is – well – higher inflation, as well as sharply higher asset prices, and a catastrophic loss of credibility in the Fed. And yet, when the trade off is social unrest – which is inevitable if the Fed plans to keep rates at 5% or higher for several years – then the alternative is palatable. So palatable, in fact, that as we reported in November, Goldman and TS Lombard also got on board, with the former writing that “given that most would agree that a fast reduction in inflation to 2% is unlikely we can now have a debate whether raising the G10 inflation target to the 3-4% range is more optimal for reasons of maintaining employment levels or public debt sustainability than the 2% goal which would not be possible if inflation was sticky in the 6-10% range” while TS Lombard chief strategist Steven Blitz chimed in with the following:

In the end, a recession is pretty much baked in by what the Fed has done, signalled, and will do. The overall imbalance between the supply and demand for labor is too much of a driver of inflation, through wages and, in turn, services ex shelter, for the Fed to stop now and say they have done enough. Powell, in fact, was very clear there is much more to do. This does not negate the  fact that the coming downcycle will greatly impact those that AIT [average inflation targeting] was seeking to protect and are only just getting closer to even in terms of employment. None of this changes the Fed’s coming actions, what this coming hit to employment does mean is that the political cycle for the Fed is about to get a lot hotter – from all sides. This is one reason why I have long believed, as have many others, that the Fed ultimately bails and raises the inflation target to 3%. Powell does not have the same license to keep unemployment high and real growth low for an extended period as did Volcker (more so in retrospect than at the time). My guess is, Powell knows that.

Fast forward to today when yet another financial icon has joined the “raise the inflation target” bandwagon, after Mohamed El-Erian told Bloomberg TV that the Fed won’t be able to get US inflation down to its 2% target without “crushing the economy,” even though he too conceded that the central bank is unlikely to officially change that goal post, instead the Fed will have to simply pretend it has a 2% inflation target even as it resets higher.

“You need a higher stable inflation rate. Call it 3 to 4%,” El-Erian, the chairman of Gramercy Funds told Bloomberg Television. “I don’t think they can get CPI to 2% without crushing the economy, but that’s because 2% is not the right target.”

Calling the Fed “too data dependent,” El-Erian said supply-side developments, including an energy transition, the change in supply chains during the pandemic, a tight labor market and shifting geopolitical issues, necessitate the higher target inflation rate.

“It’s right to take data into account but you’ve got to have a view of where you’re going,” he said.

The problem now, El-Erian said, is that the Fed is stuck chasing an elusive 2% goal.

“You can’t change an inflation target when you’ve missed it in such a big way,” he said. He’s previously cautioned that changing the target would be a hit to the Fed’s credibility.

When asked on Friday if the Fed could “tolerate” higher inflation, El-Erian said that is “where I hope to go.”

El-Erian’s appearance follows an op-ed he wrote for Project Syndicate last week in which he said that inflation has a 75% chance of rebounding, and the Fed could end up crushing the economy as it struggles to rein in soaring prices.

“Nearly two years into the current bout of inflation, the concept of ‘transitory inflation’ is making a comeback as the COVID-related supply shocks dissipate,” Prices would then skyrocket to a 41-year-high, forcing Fed officials to walk back their words and aggressively hike interest rates in 2022 to cool off the economy.

He added the most likely scenario was inflation remaining sticky at 3%-4%, which El-Erian estimates has a 50% probability. 

“This would force the Fed to choose between crushing the economy to get inflation down to its 2% target … or waiting to see whether the US can live with stable 3% to 4% inflation,” he said, suggesting the Fed would need to keep interest rates high.

Of course, if Powell were to even hint at a soft inflation target rise, everything – from stocks, to cryptos, to kitchen sinks – would go limit up instantly.