What happens when the Fed starts cutting rates?

Author: Mohammed El-Erian, Dean of Queen's College, University of Cambridge Writing for the Financial Times

There is almost no suspense that the Federal Reserve will start a cycle of interest rate cuts next Wednesday. Indeed, recent data supports the view that the U.S. central bank should have started cutting interest rates when the rate-setting Federal Open Market Committee (FOMC) met in July.

However, while a rate cut is confidently expected next week, there is little doubt about where rates will end, the journey to get there, the impact on the U.S. economy, and the international spillovers. There is considerable uncertainty in the effects and related analyses. This uncertainty could easily catch bond investors off guard—if liquidity conditions fail to loosen significantly.

While U.S. economic growth has repeatedly proven to be far stronger than many expected, while considering the enduring potential of this "economic exceptionalism," This must be weighed against the increasing pressure felt by lower-income households. Many families have depleted the savings accumulated during the pandemic and taken on more debt, including maxing out their credit cards. The jury is still out on whether this weakness will continue to be concentrated at the bottom of the income ladder or extend upwards.

And "American exceptionalism" is just one of the once-comfortable rugs that has been pulled out of the way when analyzing the U.S. economy. The U.S. economy has also lost the stabilizing effect of a unified policy framework.

There was a long-held belief in the “Washington Consensus”—that the path to sustained economic prosperity involved deregulation, fiscal prudence, and liberalization—but now this Consensus has given way to an expanded version of industrial policy, persistent fiscal imbalances, and the weaponization of trade tariffs and investment sanctions. At the international level, the consensus on the ever-closer integration of goods, technology and finance has had to give way to a process of fragmentation that is now part of the gradual reorganization of the much larger global economy.

At the same time, the influence of another traditional pillar of analysis - the Federal Reserve's forward policy guidance - has been undermined by an over-reliance on data. It began to affect policymakers after the U.S. central bank made the critical mistake of characterizing inflation as "transitory" in 2021. The resulting fluctuations in market consensus are like "narrative ping-pong" back and forth, exacerbating the inconsistent views between the U.S. central bank and the market on basic policy impacts.

Top Fed officials stressed that both parts of the central bank’s dual mission — promoting price stability and full employment — remain relevant. But markets have shifted sharply in the past few weeks, pricing in the Fed as a single-mission central bank whose focus has shifted from fighting inflation to trying to prevent further weakness in the labor market.

At the same time, there are mixed views on how risk-mitigation considerations often associated with times of economic uncertainty should influence policymaking. Finally, there are many views on how — and when — senior Fed officials will transition from overreliance on data to a more forward-looking policy outlook.

Although such uncertainties are primarily related to the factors influencing interest rate decisions, they can have a significant impact on outcomes in three key areas: Policy neither restricts The ultimate interest rate that also does not stimulate the economy, and the journey to get there; the extent to which interest rate cuts will translate into greater non-inflationary economic growth momentum; the extent to which the Fed's interest rate cutting cycle will be a round of aggressive global (including Emerging countries included) cycle opens the door.

This complex analytical framework does not reflect how U.S. fixed-income markets, the global benchmark, are pricing in expectations for Fed policy. The government bond market is sending signals that recession risks are higher, with the Federal Reserve expected to cut interest rates by 0.50 percentage points next week or later, taking the total rate cuts to 2 percentage points over the next 12 months. However, credit market movements reflect confidence in a soft landing.

As long as financial conditions loosen further significantly - including the influx of cash currently on the sidelines, offsetting the massive government bond issuance and continued shrinkage of the Fed's balance sheet (i.e. quantitative austerity) – these asset pricing inconsistencies could be addressed in an orderly manner.

This power was clearly demonstrated on Wednesday, when the monthly core inflation data released that day rose slightly, initially causing the two-year U.S. Treasury yield to rise sharply by 0.10 percentage points, but this increase was later reversed. However, this “technical” impact is not a perfect substitute for the restoration of growth and policy pillars. It is itself an inherently unstable influence.