The Fed should change up its playbook to keep the economy from overheating, BofA says

• The Fed should pull back on its ultra-accommodative policy ahead of schedule, BofA economists said.
• The US economy is hurtling toward a full recovery and will likely exceed its maximum potential GDP next year.
• Keeping rates near zero while the economy runs so hot risks rampant inflation, the bank said.

The Federal Reserve's lower-for-longer policy strategy might need to be cut short, Bank of America economists argued Monday.

The central bank is in the middle of an interest-rate experiment. Instead of hiking its benchmark interest rate at the first sight of above-2% inflation, Fed policymakers have indicated they'll let price growth run hotter than usual in hopes of driving a stronger recovery and tighter labor market. The Fed's last set of quarterly economic projections places its first rate hike sometime after 2023.

Fed Chair Jerome Powell reiterated in an April press conference that the central bank still isn't thinking about tapering its emergency asset purchases or lifting rates. Yet Powell has also noted that the recovery has exceeded expectations and seemingly reached an "inflection point" in March.

That brighter outlook is enough for some to forecast an earlier reversal of the Fed's ultra-accommodative stance. Gross domestic product is already nearing its pre-pandemic peak, and the continued reopening will likely place output at new record highs before the year is out. Yet with new stimulus likely to be passed next year as the economy exceeds its prior peak, the Fed's plan to hold rates near zero could present new risks, Bank of America Research said in a note to clients.

"Yes, a rapid recovery means a rapid healing of wounds. Clearly we don't want to see a replay of the slow-motion recovery of the last cycle," the team led by Ethan Harris said. "However, policymakers don't seem to be ready to tap on the brakes in a timely manner as the economy approaches potential next year."

The issue of the economy's potential gets at the core of the economists' worries. The Congressional Budget Office estimates the US' maximum potential GDP, and the gap between real GDP and that estimate serves as the country's so-called output gap. Exceeding the gap for a prolonged period is thought to be harmful and typically precedes periods of recession.

The Fed is currently on track to leave rates at historic lows even as the economy exceeds its potential next year. That stance threatens to let inflation run rampant, the bank warned.

Conversely, the slow recovery seen after the Great Recession led to a hot labor market without strong inflation.

"We think a shift in the Fed's strategy next year from sole focus on growth to a more balanced focus on growth an inflation is critical to ensuring a more sustained recovery," the economists said.

Bank of America isn't alone in its new outlook. Famed economist Mohamed El-Erian called on the Fed to pull forward its plans for policy normalization in a Sunday column in the Financial Times and a subsequent interview with CNBC, as reported by Insider's Will Daniel.

The former CEO/CIO for PIMCO told CNBC the Fed is "pinning itself in a corner" by insisting that inflation is just "transitory," and he wrote in the FT that it won't be able to "cautiously tap the brakes," but will have to slam on the brakes if inflation suddenly climbs out of the Fed's comfort zone. That could undermine "what should be a long-lasting inclusive recovery," El-Erian added.

El-Erian argued the Fed is overlooking evidence that the jump in inflation has to do with "structural changes" because the long-running lack of demand in the US economy appears to be a thing of the past. The Fed's current framework was designed long before these structural changes emerged, he said, so the central bank should rethink its approach.

"It's not just time for the Fed to start thinking about less monetary stimulus. It's time for it to taper its markets interventions for the longer-term wellbeing of the economy and the structural health of financial markets," he said.