Mohamed El-Erian Says the Market Expects Too Much on Rate Cuts

Markets are happier at the prospect of Federal Reserve rate cuts than they perhaps should be, wrote Bloomberg Opinion columnist Mohamed El-Erian, who is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management; and formerly chief executive officer of Pimco. Conditions, he said, are strong for a cut in the federal funds rate in September, but probably only a 25-basis-point one. Although he said a 50-basis-point cut is still possible.

He argued that there has been good economic news lately. The Producer Price Index data came in lower than the consensus forecast, both the headline rate and the core that eliminates the volatile food and energy figures. The Consumer Price Index news met expectations last week and saw the first sub-3% results since 2021. The collection of good news set off an equities rally and a drop in U.S. government bond yields.

All this should be enough to guarantee a 25-basis-point cut in September while leaving open the door to a 50-point if the Fed decides that much stimulus is wise. But what seems likely to happen takes on a 35%-50%-15% probability distribution. The 35% represents the chance of a full-on recession. The 50% figure is the potential for a soft landing for the economy. The remaining 15% would be the possibility of a “bigger but not hotter” economy because of favorable supply shocks.

But El-Erian thinks that market participants have taken more optimism from the news than justifiable. Although not using the exact phrasing, he almost invoked Alan Greenspan’s “irrational exuberance” remark of past decades.

“At first sight, this [economic news] supports the market view that we are now looking at a total of 200 basis points of reductions, bringing the fed funds rates to 3.25%-3.5%, over the next 12 months,” he wrote. To nail down such an outcome would require two key reinforcements.

First, Fed Chair Jerome Powell at the annual Jackson Hole conference next week would have to clarify several things. First would be what the so-called R-star, or neutral rate of interest, might be. Powell has mentioned that it might be higher than it has been in the recent past, which would suggest an also higher federal funds rate going forward. He would have to explain how the country would get there and also how the Fed would pursue sustainable 2% inflation.

Geopolitical instability between Ukraine and Russia as well as in the Middle East as well as the possibility that the Fed would react too slowly to manage interest rates — a point many have suggested has already happened — could undermine the potential of a best outcome.

“With the economy weakening, these assurances are crucial to maintaining a stable and well-functioning market, and to avoiding a negative spillover from unsettling market volatility to the economy,” he said.