Markets’ pricing in of a Fed pivot could be delaying it from happening, Mohamed El-Erian said.
Market exuberance has the effect of loosening financial conditions, which could force the Fed to keep policy tight.
“The longer this phenomenon persists, the more intriguing the related complexities,” he wrote.
Market eagerness to price in lower interest rates may actually restrict the Federal Reserve from making its long-awaited dovish pivot, economist Mohamed El-Erian said.
“The more markets diverge from the Fed’s signals, the more likely they are to push the central bank to adopt the path that is detrimental to them,” he wrote for the Financial Times. “This is because markets’ affinity for rate cuts loosens financial conditions and heightens the Fed’s concerns about inflationary pressures, thereby delaying the rate cuts that the markets are betting on.”
Already, bets that monetary policy is likely to ease in early 2024, have led to the biggest monthly loosening in conditions on record in November, El-Erian said previously, with equities soaring and Treasury yields dropping across the curve.
That’s despite cautious calls from key Fed officials. At the start of this month, Chairman Jeremy Powell warned that it would be “premature” to consider policy restrictive enough, adding that the Fed was prepared to keep tightening if necessary.
“The more investors disregard the signals emitted by the world’s most influential central bank, the more likely they will find themselves on the losing side of this debate,” El-Erian wrote. “And the longer this phenomenon persists, the more intriguing the related complexities.”
While future policy will be dictated by whether the Fed’s 2% inflation target is within reach, markets may currently be convinced that the central bank will tolerate a 3% rate instead, El-Erian suggested. This would ease the need to keep interest rates elevated.
“Pursuing too low an inflation target in this environment would result in unnecessary sacrifices in growth and livelihoods, as well as a worsening of inequality,” he wrote.
Otherwise, the Fed may simply have lost credibility. That’s as the hiking cycle has been dominated by forecasting errors, delayed policy, and supervisory lapses, El-Erian said.
At the same, markets don’t have a great track record for predicting a Fed pivot, given that a dovish turn has been priced in six times since the COVID-19 pandemic.
And recessionary fears could also play a role. While this wouldn’t explain the surge in equities, it would align with developments in gold and oil markets.
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