Allianz Chief Economist: The most crucial question is, what will happen after the Fed cuts interest rates

Mohamed El-Erian, President of Queen's College, Cambridge University and Chief Economist of Allianz, wrote today that a Fed rate cut is almost certain, but many uncertainties still exist, and this complexity is not reflected in the fixed income market's pricing of Fed policy. Here are his views.

It is almost certain that the Fed will start a rate cut cycle next Wednesday. In fact, recent data supports the view that the Fed should have started doing so at the July FOMC meeting.

However, as the positive expectations for the rate cut next week emerge, there is considerable uncertainty in the analysis, including the final level of interest rates, the interest rate path, the impact of the rate cut on the economy, and the impact on international spillover effects. If liquidity conditions do not significantly ease, this uncertainty can easily catch bond investors off guard.

While the U.S. economic growth has repeatedly proven to be stronger than many expected, the potential of the ongoing "U.S. economic exceptionalism" must be balanced with the increasing pressure felt by low-income families. Many families have depleted their savings during the pandemic and taken on more debt, including maxed-out credit cards. It is still uncertain whether this weakness will be limited to the lower end of the income ladder or will spread upward.

The "U.S. exceptionalism" was once a comforting fundamental assumption or "anchor" when analyzing the U.S. economy, but now this assumption has been shaken or removed. The stabilizing effect of a unified policy framework has also been stripped away.

The long-standing "Washington Consensus" — that enduring economic prosperity involves deregulation, fiscal prudence, and liberalization — has given way to the expansion of industrial policy, persistent fiscal imbalances, and the weaponization of trade tariffs and investment sanctions. Internationally, the coherence of the increasing integration of commodities, technology, and finance has had to give way to the fragmentation process that is now part of the larger-scale gradual restructuring of the global economy.

At the same time, the influence of the Fed's forward-looking policy guidance (another traditional analytical pillar) has been eroded by a mindset overly reliant on data — this has begun to affect policymakers following the Fed's significant mistake in 2021 of qualifying inflation as transitory. The resulting fluctuations in market consensus views, like a game of "ping pong," have exacerbated the misalignment between the Fed and the market in terms of fundamental policy influence.

Senior Fed officials emphasize that the central bank's dual mandate (price stability and full employment) is still relevant, but the market has sharply shifted in the past few weeks, pricing the Fed as a single-task central bank, with its focus now shifting from combating inflation to minimizing further weakness in the labor market.

Meanwhile, there is no consensus in the market on how policy-making should be influenced by the risk mitigation considerations usually associated with uncertain economic periods. Finally, there are various views on when senior Fed officials will transition from over-reliance on data to more forward-looking policy views.** Although these uncertainties are mainly related to factors influencing interest rate decision-making, they have had a substantial impact on the outcomes in three key areas: neither suppressing nor stimulating the final level and path of interest rates in the economy; to what extent rate cuts will translate into greater non-inflationary growth momentum; and to what extent the Fed's rate-cutting cycle will kick off a global easing cycle including emerging countries.

This complex analytical landscape is not reflected in the pricing of Fed policy in the U.S. fixed income market, which serves as a global benchmark. The U.S. bond market has sent out high recession risk signals, seeking a 0.50 percentage point rate cut by the Fed next week or shortly thereafter, and a total of 2 percentage points cut over the next 12 months. However, the credit market is pricing in an economic soft landing with confidence.

As long as financial conditions are further significantly eased, including the use of off-balance sheet cash injections to offset the heavy government bond issuance and the Fed's balance sheet contraction known as quantitative tightening, these asset pricing inconsistencies can be orderly resolved.

This was reflected on Wednesday when the two-year U.S. Treasury yield surged by 0.10 percentage points due to a slight uptick in core CPI month-on-month rate. However, this "technical" impact is not sufficient to replace the recovery of growth and policy anchors. It is inherently an unstable factor