Allianz El-Erian believes the Fed should improve its “word of mouth” and accept slightly higher inflation to avoid a recession, while investors overreact to expectations of interest rate cuts.

On December 5, Allianz's chief economic adviser, El-Erian, told the media that recently, financial markets have fluctuated sharply because traders are betting on the Fed's interest rate cut. This expectation is due to signs of declining inflation and Federal Reserve Chairman Powell's recent statement that policy is at a restrictive level, limiting economic development. This kind of statement may make the market think that the Fed is unlikely to raise interest rates further sharply, or even cut interest rates soon in the future.

Erian believes that the Fed's forward-looking guidance has been completely ignored by the market, just like last Friday. The market is actually telling the Fed: “I don't care what you think about interest rates; I think you're going to do something completely different.” The Fed's “verbal regulation” of interest rates is failing.

Erian warned that the essence of forward-looking guidance is to make the market listen to you. Through forward-looking guidance, the central bank hopes that the market can adjust itself, thereby reducing the need to directly intervene in the market. The Federal Reserve needs to regain its credibility in providing forward-looking guidance to the market. If the market does not believe in the Fed's forward-looking guidance, then market behavior may contradict the Fed's policy intentions, thereby weakening or even offsetting the effects of the Fed's policy. The Federal Reserve continues to face significant challenges in terms of communication and credibility.

Erian pointed out that the Fed needs to see the labor market cool down before implementing a loose monetary policy. He also expressed concern about continued inflation in the service sector.

Because continued service sector inflation means that the cost of living may rise, affect consumers' ability to spend, and pose a threat to overall economic stability.

Erian believes that since the global labor market and supply chain have experienced significant changes after the pandemic, the current situation is more appropriate for the 3% inflation target. The Federal Reserve should continue to promise to achieve the long-term 2% inflation target, but at the same time accept an inflation rate higher than 2% in the short term. The Fed should be more inclined to accept higher inflation rather than to achieve its 2% inflation target and cause the economy to fall into recession. The market's idea that the Fed will cut interest rates soon is wrong, and investors have overreacted to expectations of a sharp cut in interest rates.

The Fed now faces two options: either risk plunging the economy into recession and stick to the 2% inflation target; or accept slightly higher inflation and avoid a recession. He wants the Fed to choose the latter.

Erian believes, however, that in order to maintain its long-term credibility, the Fed may not actually raise its inflation target of 2%.

Editor/Somer