Fed needs to cut interest rates sooner rather than later

The Federal Reserve must cut interest rates “sooner rather than later,” said Mohamed El-Erian, president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy.

The former CEO of PIMCO argues that while the exact timing of the first rate cut may seem less critical, it is actually vital for determining the overall impact of the rate-cutting cycle on the economy.

El-Erian points out that many market participants are currently fixated on whether the Federal Reserve, reassured by the latest inflation data, will begin its rate-cutting cycle in September or delay it further, as suggested by several Fed officials. However, analysts believe this view underestimates the importance of the timing of the first cut.

“In current circumstances, the timing is crucial for determining the cumulative magnitude of the cycle and the economy’s wellbeing,” El-Erian said in his article for The Financial Times.

Typically, the timing of the first rate reduction allows markets to price in the entire cutting cycle with more confidence. Yet, this is less relevant today, given the Federal Reserve’s data-dependent approach, which lacks a strategic view.

According to El-Erian, this approach has deprived fixed-income markets of clear guidance, resulting in volatility in US Treasury yields. For instance, in the four weeks before the last Fed policy meeting, the 2-year yield fluctuated significantly, while the 10-year yield exhibited similar volatility.

He argues that the timing of the rate cuts is key to the state of the economy. There are increasing signs of economic weakening, including deteriorating forward-looking indicators and significant erosion of balance sheet buffers held by small businesses and lower-income households.

“The vulnerabilities, likely to increase as more of the lagged effects of the large 2022-23 hiking cycle take hold, come amid significant cyclical economic and political volatility, as well as transitions in areas such as technology, sustainable energy, supply chain management and trade,” El-Erian wrote.

Historically, timely rate cuts have contributed to better economic outcomes. Analysts cite the example of the swift rate cut following the 3 percentage point hiking cycle in 1994-95, which helped achieve a so-called „soft landing.” This historical precedent suggests that a well-timed rate cut could lead to a similar positive outcome in the current economic landscape, El-Erian argues.

They warn that delaying the first rate cut increases the likelihood that the Fed will need to cut rates more aggressively later to minimize the risk of recession. This scenario would mirror the Fed’s initial policy mistake in 2021-22 when it mischaracterized inflation as „transitory” and delayed its policy response, leading to aggressive rate hikes.

“If, this time around, the Fed is forced into a large cutting cycle due to a delayed start and accelerating economic and financial weaknesses, it would also have to end up cutting by more than necessary based on longer-term conditions,” El-Erian says.

“Rather than a given, the terminal rate for the upcoming Fed rate reduction cycle depends on when it starts. The longer central bankers wait to cut, the more the economy risks unnecessary harm to its growth prospects and financial stability, hitting the more vulnerable segments particularly hard,” he added.

In doing so, the Fed would once again find itself reacting to crises rather than proactively guiding the economy toward the soft landing that many hope for.