The US Federal Reserve is losing control of its messaging on interest rates, but financial markets are wrong to expect imminent cuts, Allianz Chief Economic Adviser Mohamed El-Erian said.
El-Erian, a Bloomberg Opinion columnist, said the Fed may well tolerate higher inflation instead of pushing the economy into recession to hit its 2% target. But he also said investors are over-reacting by pricing in sharp rate cuts.
Market prices have swung wildly in recent days as traders bet on a drop in borrowing costs amid signs that inflation is falling and comments from Fed Chair Jerome Powell that the actions taken so far have pushed policy “well into restrictive territory.”
Speaking to Bloomberg Radio on Tuesday, El-Erian warned that the Fed needs to recover its credibility on forward guidance with the markets or the recent “tremendous loosening of financial conditions” will undermine its policy.
“I do believe the Fed is done raising rates, but I don’t think that validates what is in the markets about rate cuts next year,” he said. “They still have a significant communication problem and they still have a credibility problem.”
“The whole point of forward guidance is for the markets to listen to you and for the markets to do the heavy lifting for you. What we’re seeing now is forward guidance, as we saw last Friday, is being completely ignored by the market.”
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“The market’s basically telling the Fed ‘I don’t care what you think about an interest rate that you set, I think you’re gonna do something completely different’. That’s quite a statement from the market to the Fed.”
El-Erian said the Fed will want to see more signs of easing in the labour market before loosening policy and that the persistence of services sector inflation is troubling.
He said central banks need to be “more humble” about their role because we “live in a different world” with less flexible labour markets and supply chains.
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Rather than tackle inflation aggressively now, the Fed should “continue to promise us 2% in the future but tolerate higher inflation – ie. don’t get to 2% very quickly.”
Post-pandemic changes to labour markets and supply chains may make a 3% inflation target preferable, but the Fed is “not going to revise up the 2% target because they don’t want to undermine their credibility,” he said.
“Ultimately the choice facing the Fed is the following: Either they stick to 2% and risk dipping the economy into recession; or tolerate slightly higher inflation, don’t push the economy into recession and find out that that is stable, that it doesn’t de-anchor inflationary expectations,” he said. “My hope is that they will opt for the second option.”
