Top Economist: The Fed's significant rate cut is another evolution of the liquidity-driven paradigm

Mohamed El-Erian, Dean of Queen's College, University of Cambridge, and advisor to Allianz Group and Gramercy, recently wrote that the significant rate cut by the Federal Reserve is another evolution of the liquidity-driven paradigm. The mechanism of providing ample liquidity to the market by the Federal Reserve has now become a policy to guard against increasingly broad risks. Below are his viewpoints.

Powell's unusually proactive initiation of a rate cut cycle by the Federal Reserve has reinforced the market's belief that we have never, and are unlikely to soon, exit the monetary policy mechanism that first emerged before the global financial crisis in 2008.

The Federal Reserve providing ample liquidity to the market has now become a policy to guard against increasingly broad risks.

The Federal Reserve's initiation of a rate cut cycle by reducing rates by 50 basis points is relatively uncommon. According to Powell, in a situation where the economy is "in good shape," the Federal Reserve is "increasingly confident in the strength of the labor market," and fiscal policy has been so loose, this situation is even more unusual.

There have been many economic reasons put forward for the Federal Reserve's aggressive cycle initiation, which should not come as a surprise. These reasons range from the "mission accomplished" of fighting inflation to the high risk of an unsettling economic recession. Other reasons mentioned include spillover effects from economic issues in Asia and Europe, and abnormally high real interest rates after considering inflation factors.

Non-economic reasons that have also been mentioned involve political factors before the presidential election, concerns that escalation of tensions in the Middle East and Russia-Ukraine could disrupt global demand, and even threats to the Federal Reserve from the market, which believes the Federal Reserve should act as a central bank with a single mission, focusing only on the "full employment" part of its dual mandate.

Given the recent magnitude of rate cuts, such speculation is natural, especially considering the current market disharmony, which includes the contrast between record-high stock markets and economic, political, and geopolitical uncertainties; despite concerns about high levels of private and public sector debt, there is a strong appetite for large-scale new bond issuances; there has been historically unusual correlation among government bonds, high-yield bonds, and gold, all of which are rising.

Following the first set of remarks made by Federal Reserve officials after the Federal Open Market Committee meeting, there is no unified reason given for the significant rate cut. Instead, we must wait for data releases in the coming weeks to retrospectively assess the Federal Reserve's rationale. If I were to express an opinion today, I would describe this rate cut as a combination of two factors: one being a precautionary policy taken by the Federal Reserve to prevent new policy mistakes, i.e., to prevent implementing overly tight policies for too long; and the other being that both the Federal Reserve and the market believe the cost of this policy is very low.

From a longer-term perspective, this is another evolution of the liquidity-driven paradigm, also known as what some call financialization of the economy. As detailed in an article I published in the Financial Times in the UK in 2007, the excessive activity of private sector credit factories before the global financial crisis erupted in 2008 exemplified this Under the support of liquidity, policymakers have conducted large-scale market interventions to reduce the possibility of disorderly deleveraging of private sector balance sheets. This has reinforced the widespread belief in the "Fed put" - the prospect of the Fed providing market support during times of market turmoil. During the 2019 COVID-19 pandemic, with a staggering budget deficit, the Fed's balance sheet surged from $1 trillion before the financial crisis to $9 trillion, amplifying this impact. Despite the unemployment rate staying below 4% for 27 consecutive months as of May last year, setting a historical record.

The result of all this is that liquidity has decoupled market pricing from traditional economic, financial, geopolitical, and political factors. In fact, recent rate cuts have fueled significant behavioral biases, leading the market to believe that ample liquidity support can not only help them navigate the uncertain reality but also preempt various threats in the future.

It's no wonder many describe the Fed's rate stance as a form of "insurance policy." Its beneficial effects are often accompanied by generous insurance, balancing high moral hazards and adverse selection. Specifically, the market interprets this as a signal of rising inflation and lower financial instability risks.

A properly priced insurance policy can increase economic welfare in a win-win-win manner, benefiting policyholders, insurers, and the entire system. This is the hope on which current economic welfare is to some extent based, but it is by no means an easy task