This article is written by Mohamed El-Erian, the Dean of Queen's College at Cambridge University and an advisor at Allianz.

Market participants and economists generally believe that the Federal Reserve will cut interest rates at its policy meeting this week. At the same time, it is expected that this will be accompanied by forward guidance, suggesting that the number of rate cuts in 2025 will be fewer than previously anticipated, with a higher terminal rate and a pause in January next year. Additionally, much will depend largely on how the Federal Reserve's views on inflation evolve, as inflation rates have remained stubbornly above the 2% target.

The market expects a greater than 90% chance of a 0.25 percentage point reduction in the federal funds rate this week. Although there are differences in predictions among officials, it is still expected that they will outline a higher interest rate path in the "dot plot" and that the terminal rate will be closer to market expectations.

Finally, although Federal Reserve Chairman Powell will not completely abandon all policy options for January next year, it is expected that he will signal at the press conference that the Federal Reserve will maintain the current status quo when the Federal Open Market Committee (FOMC) meets next month.

The situation after January next year has become an interesting topic of debate. Many anticipate that after "skipping" one rate cut, monetary easing will be restored, continuing to lower rates at a quarterly pace throughout 2025. Some prefer to view this as a "pause" in rate cuts, holding greater uncertainty for future reductions. At least for now, very few believe that the rate cut this week could be the endpoint of the current rate-cutting cycle.

Different assessments regarding inflation, economic conditions, and the intentions of the incoming government's policies explain the diversity of opinions. Additionally, the final divergence between the Federal Reserve's easing path for 2024 and last year's market consensus has resulted in about 75 basis points, which also plays a role.

Last week's inflation data showed that the process of returning to the Federal Reserve's 2% target has now become more hesitant, a phenomenon noted by few for some time. The report released last week indicated that the consumer price index (CPI), excluding volatile food and energy costs, increased by 0.3% month-on-month for the fourth consecutive month. The producer price index report released the following day was hotter than expected. The components of these two reports indicate that the core personal consumption expenditures index (PCE) cannot quickly reach 2%.

It is noteworthy that this data aligns with a series of positive surprises brought by reports on economic activities. Although very few are eager to confidently estimate the specific impact of President Trump's policies, most believe that a combination of higher tariffs, immigration restrictions, repatriation measures, and fiscal pressures may bring inflation effects before significant deregulation and liberalization yield supply-side benefits. After all, we also have indications that liquidity conditions are quite loose.

In this context, the Federal Reserve will soon be forced to face an important policy choice that affects the sustainability of American economic exceptionalism and the health of the stock market.

Should the Federal Reserve implicitly and explicitly reaffirm its 2% inflation target and double its efforts to achieve this goal? Powell stated last month, 'We will not guess, we will not speculate, and we will not assume' the policies of the new administration. Sticking to the current goal will still involve the Federal Reserve implementing a relatively 'hawkish' rate cut this Thursday morning. In closed-door meetings, the future idea of rate cuts will shift from 'We can continue to cut rates because reaching our inflation target is just a matter of time' to 'We need to maintain policy tightening for much longer than expected.' In fact, in this case, a complete 180-degree policy reversal, including rate hikes, is not entirely impossible.

Otherwise, should it implicitly acknowledge that the equilibrium inflation rate of the economy has risen due to various ongoing structural changes both domestically and abroad? If the US economy can operate with an inflation rate close to 3% without adversely affecting expectations (nor harming the growth outlook), then the more the Federal Reserve tries to force the economy to strictly meet the 2% inflation level, the greater the threat to American economic exceptionalism, the stock market, and financial stability.

It needs to be clarified that the second situation does not mean that the Federal Reserve would openly abandon its inflation target and shift to a new range of 2.5%-3%. Given its failure to meet this target over the past three years, such a situation is unlikely to occur. Instead, the Federal Reserve will only keep postponing the timeline for reaching the current target in public statements. In closed-door meetings, however, it will temporarily execute policies according to a de facto higher target. How long this state will last partly depends on the government's progress in enhancing productivity, supply-side policies, corporate pricing strategies, and global economic development.

To address what I believe to be an inevitable decision point, the Federal Reserve must change the way it formulates policy. It needs to shift from currently over-relying on Historical Data to adopting a more strategic, forward-looking approach. The choices it makes will significantly impact economic growth, as well as market valuations and volatility—not only in the USA, but globally.

Editor/Rocky