Don’t want the Fed to suspend rate hikes in September

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Last week’s rise in stock prices suggested that many investors still want the Federal Reserve to step in to counter downward pressures in the market. Hopes for this “Fed Put” may, however, confuse the Fed’s willingness to act with its ability to do so.

Markets breathed a notable sigh of relief last week when Atlanta Fed President Raphael Bostic opened the door to the possibility that the Fed would suspend rate hikes in September. Such a hiatus would be justified not by the resumption of inflation control by the Fed, but rather by concerns about the effects of a continued tightening on the stock markets.

It is premature for investors to hope that such an early pause would boost stocks.

Given the persistence of high inflation, the Fed is theoretically prohibited from easing short-term financial conditions just to support the stock market. This constraint could, however, be relaxed in two ways, one good and one bad.

First, an already lagging Fed could theoretically be quick to fight inflation. This would require improvements on the supply side of the economy, due to the resolution of supply chain bottlenecks and higher productivity growth. Such a scenario would also require increased labor force participation, and a mix of accumulated personal savings and targeted government support would get most households through the transition period.

The wrong path involves income-related issues that amplify the pressure on households from rising prices. In this case, aggregate demand will fall across the economy as reduced consumption discourages business investment and exports, and a playing catch-up Fed miscalculates the effects of simultaneously rising rates and of the contraction of its balance sheet. Inflationary pressures would ease, but at a significant cost to the economic, social, and financial well-being of Americans.

While we should hope for the first possibility and take steps to avoid the second, it is unrealistic to expect either to unfold within the next three months. It is therefore difficult to find a convincing argument at this stage for the Fed to suspend rate hikes in September after the widely expected 50 basis point hikes on June 15 and July 27.

That doesn’t mean the Fed won’t be tempted to take a break in September. Considering how long the Fed sat last year erroneously labeling inflation as transitory, it’s not out of the question that the Fed could again do something it shouldn’t.

One of the biggest political threats to economic stability over the next 18 months is that the Fed will find itself in a go-stop-go cycle – that is, raising rates then stopping, to be forced to start over. A belated first and then U-turn would condemn the US economy to a much longer period of painful stagflation and increase the risk of recession.

For years, the Fed has shown a strong willingness to intervene to counter the pressure on asset prices, and this willingness may well continue. But this is no longer a determining factor. What’s at stake now is capacity. This capacity will not be restored by September unless inflationary indicators fall sharply due to a substantial and very damaging decline in economic activity. And that’s not something investors should want.

More from Bloomberg Opinion:

• Fed’s subdued inflation forecast needs explaining: Bill Dudley

• This Risk-On rally rests on risky foundations: John Authers

• Has US consumer spending just peaked? :Robert Burgess

(Corrects spelling of Raphael Bostic in second paragraph.)

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Mohamed A. El-Erian is a Bloomberg Opinion columnist. Former CEO of Pimco, he is President of Queens’ College, Cambridge; Chief Economic Advisor at Allianz SE; and President of Gramercy Fund Management. He is the author of “The Only Game in Town”.

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