Source: Jin10 Data

Mohamed El-Erian, President of the Queen's College, Cambridge University and Chief Economist of Allianz, recently wrote that the Federal Reserve needs to cut interest rates early. Here are his views.

"When the Federal Reserve begins to cut interest rates is not important. What is really important is where they will eventually cut."This is a view widely circulated on Wall Street recently.

At first glance, this suggestion seems like a timely warning to many market participants who are obsessed with whether the Federal Reserve will be encouraged by the latest inflation data to begin its rate cuts cycle in September or wait longer, as some Fed officials hinted last week.

However, this view overlooks the importance of the timing of the first rate cut. In the current context, the timing of the first cut is crucial to determining the cumulative amplitude of the entire cycle and the health of the U.S. economy.

Arguments about the importance of timing usually suggest that the first rate cut can make the markets more confident in pricing the entire rate cut cycle. However, in facing the Fed that relies too much on data today, this seems less important. The Fed avoids taking a strategic perspective, unfortunately, this approach is unlikely to change in the short term.

The lack of policy anchoring has deprived the fixed income market of an important guiding signal. You can see this in the behavior of U.S. Treasury yields, whether it's the policy-sensitive two-year U.S. government bonds or the 10-year U.S. bonds that reflect the overall market view of the rate cycle and inflation and growth outcomes.

In the four weeks leading up to the last Fed policy meeting alone, the two-year Treasury yield swung wildly, rising to nearly 5%, then falling 0.26%, then rising 0.18%, and then falling again 0.22% to a low of 4.67%. The 10-year Treasury yield has shown similar volatility, but on a larger scale.

A stronger argument for the importance of timing is related to the state of the economy. More and more (although not yet universal) data suggest that the economy is weakening, including the deterioration of leading indicators. This coincides with the significant reduction in balance sheet buffers held by small businesses and low-income households. As the lagging effects of the massive rate hikes cycle of 2022-23 gradually become apparent, the fragility of the U.S. economy may increase, all of which are occurring in significant cyclical and political economic turbulence, as well as in the transformation processes in areas such as technology, sustainable energy, supply chain management and trade.

Historically, timely rate cuts have helped achieve better economic outcomes. As Bob Michele of JPMorgan emphasized in an interview last week, rapid rate cuts played an important role in achieving a "soft landing" for the U.S. economy after the rate hike cycle of 1994-95, which was rare in history. This historical precedent should inspire optimism and indicate that timely rate cuts could bring similar positive results in the current economic context (I currently estimate the probability of a soft landing at 50%).

In view of the inflation dynamic, delaying the first rate cut increases the possibility that the Fed will ultimately need to cut rates more sharply to minimize the risk of recession. This situation will constitute the opposite of Fed policy errors in 2021-22. At that time, the Fed erroneously described inflation as "transitory" and delayed policy responses, later having to aggressively hike rates by over 500 basis points, including four consecutive hikes of 75 basis points.

If this time, due to the delayed start and the acceleration of economic and financial weakness, the Fed is forced to engage in a large-scale rate cut cycle, it will also have to cut more unnecessary funds based on long-term conditions. This follow-up over-rise, exposing areas of financial fragility, and policy challenges for many other countries abroad.

Fragile families and small businesses will be most sensitive to this overreaction. The benefits of lower rates will be overshadowed by increasing income insecurity or direct unemployment.

The final rate of the Fed's forthcoming rate-cut cycle depends on when it begins. The longer Fed officials wait for rate cuts, the more likely the U.S. economy is to suffer unnecessary damage to its growth prospects and financial stability, especially to those most vulnerable. In the process, the Fed will again fall into a passive policy response, focusing on "fire-fighting" rather than strategically guiding the economy to achieve the soft landing that many people hope to see and the world urgently needs.

Editor/Lambor