Mohamed El-Erian: Why should the Fed raise rates by 50 points?

Some market and economic indicators support such policy action, but it is far from uniform. In fact, my broader analysis of economic and financial conditions would favor the option of the Fed raising rates by 50 points, also due to risk management, credibility, and the persistent misalignment between market prices and policy stance. forward from the central bank to 2023.

Through the details of the Fed’s December policy meeting and numerous speeches since then, policymakers have guided markets to expect the central bank to raise rates by 25 basis points, states a maximum rate of just over 5% for this cycle of increases and keep it at that level for the rest of 2023.

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Despite what has been an unusually uniform and consistent message from Fed bankers, markets continue to refuse to fully price in this monetary policy guidance. Instead, traders expect the Fed to cut rates in the second half of the year and are backing that belief with their bets.

This leaves the Fed with three priorities for next week’s policy meeting: convincing markets of its policy outlook for the year; implement monetary policy action consistent with this; and thus partially repairing his credibility, which was damaged by his gross mischaracterization of inflation for most of 2021 and then by an overly modest initial monetary policy response.

The Fed seems to believe that a 25 basis point hike is consistent with this objective, up from December’s 50 point hike and, before that, four consecutive record 75 point hikes. The argument in favor of such a shift towards a reduction in increases goes beyond the expectation that an already declining inflation rate will continue to fall in the coming months.

It also seems consistent with the significant level of economic fluidity both domestically and internationally and, as the Fed chair explained, Jerome Powell, with the notion of walking slowly in a dark room to better perceive the path. This consideration becomes more important in the context of forward-looking indicators that suggest a still high probability of recession, including deeply reversing segments of the US Treasury yield curve.

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However, these arguments are not without notable counterparts. To get started, consider the following four:

• While inflation will continue to decline for the foreseeable future, its main drivers have shifted to the services sector, raising the risk of more entrenched price pressures as the labor market remains strong.
• As global growth continues to surprise on the upside, the window for more orderly rate hikes has widened.
• Financial conditions have eased significantly in recent months and, by some measures, are around the levels that prevailed last March, when the Fed started this hike cycle.
• Getting to the top rate more quickly, which has already been noted and reiterated by Fed bankers, reduces the complexities of tying the path to a variable destination.

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There are also strong risk management arguments in favor of another 50 basis point increase before slowing to 25 basis point gains.

Such policy action reduces the risk of having to raise rates later this year, when the global economy has weakened. It can help reverse some of the damage to the Fed’s inflation-fighting credentials, starting with better alignment between central bank monetary policy guidance and market pricing. Furthermore, in an inherently fluid world where the probability of another monetary policy mistake is uncomfortably high, it allows for an easier recovery in the event of such a mistake.

While it is true that the Fed walks in a dark room, it is also true that time is of the essence and the Fed does not have as much as it wants. In fact, after being twice behind (in understanding and responding to the current inflationary phenomenon), another mismanagement of time would be detrimental not only to central bank credibility and the future effectiveness of monetary policy, but also, more importantly, for the well-being of the national economy and the global economies.