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Cutting Through the Rate-Hike Hype

Mohamed A. El-Erian is a Bloomberg View columnist. He is the chief economic adviser at Allianz SE and chairman of the President’s Global Development Council, and he was chief executive and co-chief investment officer of Pimco. His books include “The Only Game in Town: Central Banks, Instability and Avoiding the Next Collapse.”
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Let's take a deep breath: It shouldn't matter that much whether the Federal Reserve decides this week to raise interest rates by 25 basis points, or possibly even less. And the prospect of an increase certainly shouldn't produce dire warnings about another "Lehman moment" that would lead to global economic and financial calamity.

Yet the possibility that Fed officials may decide to begin to raise rates has been the central public preoccupation of many market participants, economists and former policy makers.

QuickTake The Fed's Countdown

Here are seven reasons for the unusual attention to this Fed decision; only a few of them deserve serious consideration:

The first is that a decision to raise rates at the conclusion of the Open Market Committee meeting Thursday would be the first such increase in almost 10 years. That would signal the beginning of the journey out of a prolonged period of floored policy rates that has lasted much longer than anticipated by almost everyone, including Fed officials (past and present).

Yet, by itself, the historic nature of the decision hardly justifies the excitement and emotion, or the predictions of earth-shattering consequences.

Then there is the view that the U.S. economy would be harmed by a rate hike, particularly "interest-rate sensitive" sectors such as housing and automobiles. This hoopla isn't justified, either, because it is based on an overly partial representation of the state of the economy.

Although the U.S. hasn’t attained "escape velocity" and "lift off," there is no denying the broad-based healing of the economy, including the notable strengthening of the labor market, banks and most industrial companies. Nor can one deny the exciting innovations that are taking place. There also is reason to be more optimistic about a recovery in wages. And many companies still have substantial cash on their balance sheets, having already termed out their debt and refinanced much of it at very low interest rates.

The third reason is more substantive, even if it isn't decisive on its own. It reflects justifiable worry about the global economic effect of a rate hike given the more fragile conditions outside the U.S.  

Europe and Japan are stuck in the doldrums while almost every emerging economy is slowing and some, such as Brazil and Russia, are already in contraction mode. Financial markets in these countries have responded in a highly volatile and potentially destabilizing manner. A premature Fed tightening could add to the economic headwinds, risking crisis conditions in some emerging countries, with negative feedback effects on global activity.

Although a rate increase could have some impact, the potential consequences pale in comparison to the effect of the measures other countries can and should be taking to right their economies. It is their comprehensive policy actions, or lack thereof, that will determine prospects for the global economy -- and not what the Fed decided this week.

This leads us to reason No. 4: Financial markets have become excessively reliant on central banks. This dependence has significantly untethered markets from underlying economic and corporate fundamentals. Years of rock-bottom interest rates and liquidity injections, both wrapped in a "volatility suppression" monetary regime, have encouraged investors to believe they can safely venture far and wide in search of returns that provide little cushion for the risks incurred.

There is fear that a signal of a change in the Fed's interest rate regime, no matter how small, would trigger very large capital flows and portfolio reallocations, leading to frightening financial asset air pockets that would be aggravated by patchy liquidity.

The fifth reason has to do with communication.

In recent years, Fed officials have embraced a more open channel to the markets, starting with Chairman Ben Bernanke.

Yet it has been more than two months since Bernanke's successor, Janet Yellen, has made her views known. Lacking guidance from the very top, markets have had to rely on competing narratives from Fed governors and presidents of the regional Feds.

Then there is the issue of Fed risk management, including the potential reversibility of a policy error.

The Fed is operating in an inherently uncertain environment that has no historical precedent, and it faces unusual global fluidity. As a result, the central bank is potentially in danger of making one of two mistakes: Hiking too early or not hiking early enough.

If the Fed does raise rates by 25 basis points (or less), and if this action proves traumatic for markets, the central bank can reverse course. But the potential damage of a mistaken decision and its reversal would be greater than if the Fed delayed just a little longer. This would be the case even in times when conditions for an immediate rate hike are optimal.

The final and most valid reason for concern: The Fed hasn't been able to convince markets that the interest-rate journey itself matters a lot more than the timing of the first increase. This hiking cycle, whether or not it starts this week, will be unusually dovish in pace, irregular in sequencing and will end with an interest rate that is below historical averages.

This last consideration is a sufficient reason for the Fed to wait just a little longer as it works harder to manage market expectations. It also sheds light on what else we should expect from the Fed officials, starting with Thursday’s highly anticipated news conference -- that is, stepped-up and more coordinated communication that guides markets to focus on the scale and scope of the hiking cycle as a whole, rather than a narrow preoccupation with the timing of the first step.

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

To contact the author of this story:
Mohamed A. El-Erian at melerian@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net