Should the Federal Reserve cut interest rates as soon as possible? Economists: The timing of the first cut is the most important, not the magnitude

Recently, a view has been circulating on Wall Street that "it is not important when the Fed starts cutting interest rates, what is really important is how much it cuts rates."

In response to this view, Allianz's Chief Economic Advisor El-Erian criticized in a column:

This view overlooks the importance of the timing of the first rate cut. In the current environment, the timing of the first rate cut is crucial for assessing the cumulative magnitude of the entire rate-cutting cycle and the economic situation.

El-Erian believes that the first rate cut can give the market more confidence in pricing the entire rate-cutting cycle, but the current Fed's excessive reliance on data lacks policy anchors, causing the fixed income market to lose important guidance.

This is reflected in the trend of U.S. bond yields. In the four weeks leading up to the last Fed policy meeting, the 2-year yield experienced significant fluctuations, rising to nearly 5% and then falling to a low of 4.67%. The 10-year yield also showed similar volatility, with even larger swings.

What's worse, delaying rate cuts may threaten a "soft landing" for the U.S. economy...

Delaying Rate Cuts Threatens a "Soft Landing"

El-Erian states that the importance of the timing of rate cuts is mainly related to the current economic situation.

More and more data indicate that the economy is weakening, including the deterioration of leading indicators, while the balance sheets of small and medium-sized enterprises and low-income households are significantly decreasing. As the delayed effects of the large-scale rate hike cycle in 2022-2023 gradually manifest, vulnerabilities may further intensify. In addition, the current period is characterized by significant economic and political cyclical fluctuations, with sectors such as technology, renewable energy, supply chain management, and trade undergoing transitions.

From historical experience, timely rate cuts also help achieve better economic outcomes. As emphasized by Bob Michele of Morgan Stanley, the timely rate cuts played a key role after a 300 basis point rate hike cycle in 1994-1995, achieving a historically rare "soft landing" for the economy. This means that if rate cuts are timed appropriately, there is also a 50% chance of achieving a similar benign outcome in the current economic environment, according to El-Erian.

El-Erian further warns:

Given the inflation dynamics, delaying the first rate cut will only increase the likelihood of the Fed eventually having to increase the magnitude of rate cuts, a situation that would be the opposite of the Fed's previous policy errors in 2021-2022.

If the Fed is forced to make significant rate cuts under the pressure of deteriorating economic and financial conditions due to delaying the initial rate cut, the magnitude of the rate cuts will undoubtedly exceed what is required under long-term conditions, continuing the financial vulnerabilities caused by previous excessive tightening.

Overall, El-Erian believes that the ultimate level of rate cuts is not predetermined, but depends on the timing of the first rate cut. The longer the Fed delays, the greater the risks to economic growth and financial stability. The Fed will once again find itself in a situation of reactive response, unable to proactively guide policy and only able to passively "put out fires."