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The eagerness of markets to anticipate lower interest rates might be inadvertently impeding the much-anticipated dovish pivot by the Federal Reserve, warns economist Mohamed El-Erian. In an op-ed for the Financial Times, El-Erian suggests that the increasing divergence between market expectations and the Fed’s signals could create a scenario where the central bank, concerned about inflationary pressures, delays the rate cuts that markets are betting on.
El-Erian notes that as markets enthusiastically price in the likelihood of a Fed pivot, it has the unintended consequence of loosening financial conditions. This, in turn, raises the Fed’s concerns about inflation and may lead to a delay in implementing the rate cuts that markets are anticipating.
Despite cautious remarks from key Fed officials, such as Chairman Jerome Powell, who deemed it “premature” to consider restrictive policy and expressed a readiness to continue tightening if necessary, the markets persist in their expectation of an easing cycle in early 2024. El-Erian points out that this anticipation has already resulted in the most significant monthly loosening of conditions on record in November, with equities surging and Treasury yields dropping.
The potential disconnect between market expectations and the Fed’s actions poses challenges and complexities. El-Erian emphasizes that as investors increasingly disregard signals from the influential central bank, they may find themselves on the losing side of the debate. He underscores that the longer this divergence persists, the more intriguing the associated complexities become.
The economist suggests that the Fed’s future policy direction hinges on whether the 2% inflation target is achievable. However, markets may be currently convinced that the central bank would tolerate a 3% rate, alleviating the need to keep interest rates elevated. El-Erian argues against pursuing too low an inflation target, as it could result in unnecessary sacrifices in growth, livelihoods, and exacerbate inequality.
Furthermore, El-Erian raises the possibility that the Fed may have lost credibility, citing forecasting errors, delayed policy decisions, and supervisory lapses during the current hiking cycle. Despite market expectations, he points out that predicting a Fed pivot has proven challenging, especially given the multiple instances of dovish turns priced in since the onset of the COVID-19 pandemic.
El-Erian concludes by suggesting that recessionary fears could be influencing market behavior, aligning with developments in gold and oil markets, even if they don’t fully explain the surge in equities. The intricate interplay between market dynamics, the Fed’s messaging, and economic indicators adds complexity to the unfolding narrative of monetary policy and its impact on financial markets.
