Analysis | Why the Fed Should Raise Rates by Half a Percent

Through the details of the Fed’s December policy meeting and numerous speeches since, policymakers have guided the markets to expect the central bank to increase rates by 25 basis points, establish a peak rate of just more than 5% for this hiking cycle and keep it there for the rest of 2023. Despite what has been an unusually uniform and consistent message from Fed officials, the markets continue to refuse to fully price in this policy guidance. Instead, traders expect the Fed to cut rates in the second half of the year and are backing that up with their bets.

This leaves the Fed with three policy priorities for next week’s policy meeting: Convince the markets of its policy outlook for the year; implement a policy action consistent with this; and, therefore, partially repair its credibility, which was damaged by its gross mischaracterization of inflation for almost all of 2021 and, after that, too modest an initial policy response.

The Fed seems to believe that a 25-basis-point increase is consistent with this goal, down from 50 points in December and, before that, a record-breaking four consecutive 75-point increases. The case made for such a downshift goes beyond the expectation that an already declining inflation rate will continue to fall in the months ahead. It also appears consistent with the significant level of economic fluidity, domestically and internationally — or, as framed by Fed Chair Jerome Powell, the notion of walking slowly in a dark room to better feel one’s way through it. This consideration takes added importance in the context of forward-looking indicators suggesting a still-high probability of recession, including deeply inverted segments of the US Treasury yield curve.

 Yet these arguments are not without notable counters. Consider the following four as starters: 

• While inflation will indeed continue to come down in the immediate future, its main drivers have been shifting to the service sector, thereby increasing the risk of more embedded price pressures when the labor market remains solid.

• With global growth surprising on the upside, the window for more orderly rate increases has been opened wider.

• Financial conditions have loosened significantly in recent months and, by some measures, are around levels that prevailed last March when the Fed initiated this hiking cycle.

• A faster journey to the peak rate that has already been signaled, and reiterated by Fed officials several times, reduces the complexities of linking the path to a variable destination.

 There are also strong risk-management arguments in favor of another 50-point increase before downshifting to 25 basis points.

 Such a policy action reduces the risk of having to increase rates later this year when the global economy has weakened. It may help reverse some of the damage to the Fed’s inflation-fighting credentials, starting with a better alignment between the central bank’s policy guidance and market pricing. Also, in an inherently fluid world in which the probability of yet another policy mistake is uncomfortably high, it allows for an easier recovery in the event of such an error.

While it is true that the Fed is walking through a dark room, it is also true that time is of the essence. The Fed does not have as much time as it wishes. Indeed, having already fallen behind twice — in understanding the current inflation phenomenon and in responding to it — further clock mismanagement would be damaging not just to the central bank’s credibility and future policy effectiveness but also, importantly, to the well-being of the national and global economies.

More From Bloomberg Opinion:

• Historic Contraction in M2 Gives Fed Cover to Pause: Karl Smith

• Economists Now Have a Good Excuse for Being Wrong: Tyler Cowen

• Central Banks Should Put Growth Before Pride: Marcus Ashworth

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

Mohamed A. El-Erian is a Bloomberg Opinion columnist. A former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz SE; and chair of Gramercy Fund Management. He is author of “The Only Game in Town.”

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