‘The Fed got itself into a cognitive trap’

The Bank of England announced its biggest rate hike since 1995 on Thursday, following the lead of the Federal Reserve in the U.S., which has been raising rates to respond to skyrocketing inflation. But some Fed watchers believe the U.S. central bank acted too slowly.

The Federal Reserve became ensnared in a “cognitive trap” that made the central bank believe inflation was fleeting, Mohamed El-Erian, Allianz SE chief economic adviser and ex-PIMCO CEO, said in a recent episode of “Influencers with Andy Serwer.”

Inflation has hit a new 40-year high, and the latest numbers showed a jarring spike of 9.1% year-over-year. El-Erian says the Fed bears responsibility for how high inflation has skyrocketed.

“Had [the Fed] listened to companies, they would have been much more humble in saying that we don’t quite understand the inflation dynamics… and yet the Fed got hooked on this notion that it’s transitory, and then it got itself into a cognitive trap,” he told Yahoo Finance’s editor-in-chief, Andy Serwer.

The term “transitory” is a pointed reference. El-Erian, who’s also president of Queens’ College, Cambridge, is alluding to Fed Chair Jerome Powell’s 2021 assertions that price increases were “transitory.” Ultimately, Powell walked that back, eventually telling Congress in November that it was “a good time to retire that word.”

El-Erian — who has become one of central banking’s most famous watchers — believes that the Fed overall and Powell specifically made a dire mistake when approaching inflation. Thinking of inflation as short-term allowed the Fed to resist making policy changes necessary to bring it down. He believes that would have included laying off quantitative easing, or QE, a form of monetary policy where a central bank purchases securities to increase money supply and lower interest rates.

El-Erian and QE go way back

QE began in November 2008, in the depths of the Great Financial Crisis, and its goal was to spur economic activity in conjunction with low interest rates, resulting in cheap money that could theoretically send the U.S. economy barreling forward. And over the years, many have argued that it worked, though others disagree. The Fed continued with various iterations of QE for more than a decade. Critics say the market became hooked on the flowing cash, resulting in crises when the Fed tried to turn the QE faucet off — as was the case with the 2013 “taper tantrum.”

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El-Erian’s PIMCO was involved in advising the Fed when it first pursued QE, but over time he’s become critical of the practice and advocated for policies to “normalize.”

Consumer prices rose quickly throughout 2021, though many thought those rises might be temporary in light of the supply chain crisis.

However, it’s since become clear that consumers are likely to keep getting squeezed in the foreseeable future, whether it’s gas or groceries, given the Labor Department’s June numbers. Accordingly, the Fed has sought to combat inflation by shrinking its balance sheet and raising rates. In fact, just last week, the Fed announced its second consecutive rate hike of 0.75 percentage points. However, El-Erian argues that the Fed let the problem get out of hand, and didn’t pivot quickly enough.

“You ended up with this absurd situation in March, still pumping in liquidity,” he told Yahoo Finance. “It was still doing QE in March… So, it’s bad analysis, bad forecast, too-little-too-late, and miscommunication ‚ and that’s how we’ve ended up in this mess.”

Of course, El-Erian isn’t the Fed’s only critical watcher, as other notable names like former Fed governor Robert Heller, former Federal Reserve Bank of New York president William Dudley, and even ex-Fed chair Ben Bernanke have all questioned the central bank’s approach to inflation in the last few months.

Allie Garfinkle is a senior tech reporter at Yahoo Finance. Find her on Twitter @agarfinks.

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