Why hopes of a December rate cut are falling

Key Concepts

• Economic Cockroaches vs. Termites: A distinction between unpleasant but non-systemic economic risks ("cockroaches") and those that undermine the system's integrity ("termites").
• K-Shaped Economy: An economy where wealth creation is uneven, benefiting higher earners and asset owners while lower-income households struggle.
• Rational Bubble: A market phenomenon where speculative investment is justified by the potential for significant future payoffs, even if current valuations seem inflated.
• Fed Independence: The principle that the Federal Reserve should operate free from political pressure to make monetary policy decisions based on its dual mandate.
• Dual Mandate: The Federal Reserve's objectives of maximizing employment and maintaining stable prices (low inflation).
• Data Dependency: The Federal Reserve's practice of basing monetary policy decisions on incoming economic data.
• Forward-Looking vs. Backward-Looking Policy: A debate on whether the Fed should primarily react to past data or proactively strategize based on future economic trends, particularly with AI's impact.
• Bifurcated Economy: An economy characterized by two distinct speeds, with high-end consumers and large companies benefiting from trends like AI, while lower-end consumers and small businesses face challenges.
• Neutral Rate: The theoretical interest rate that neither stimulates nor restricts economic growth.
• Disinflation: A slowdown in the rate of inflation.
• Cyclical vs. Structural Risk: Cyclical risk relates to the natural ups and downs of the economic cycle, while structural risk involves fundamental weaknesses in the financial system or market.

Economic Outlook and Risks

The "Cockroach" Analogy and Systemic Risk

Mohamed El-Erian distinguishes between "economic cockroaches" and "termites." Cockroaches are unpleasant, appear in groups, and represent risks like credit or economic accidents that arise from individuals stretching for returns in a period of loose financial conditions. However, they do not "eat away at the integrity of the system." Termites, conversely, would represent systemic shocks that undermine the foundation of the economy. El-Erian believes we will see "cockroaches" but not "termites," implying a lack of systemic collapse.

Pressures on Lower-Income Households

A primary concern for El-Erian is the significant pressure on households at the lower end of the income distribution. This pressure stems from:

• Inflation: While the initial 2021-2022 inflation shock was offset by income transfers, inflation is now "stuck at 3%."
• Income Insecurity: Layoffs are surging (as indicated by the Challenger report), and the impact of AI on the workplace creates uncertainty about future income.
• High Debt: Households have maxed out credit cards and face the prospect of refinancing debt at higher interest rates.

This situation contributes to a "K-shaped economy," where the wealth created in markets is not translating to the average US household. El-Erian warns that if lower-income households stop spending due to inability rather than unwillingness, it will "contaminate upwards for the economy as a whole." He is not concerned about the middle to upper classes, who are doing well from both income and wealth perspectives.

Refinancing Debt at Higher Interest Rates

Another significant concern is the "amount of debt that has to be refinanced at higher interest rates." This poses a potential area of pressure, exacerbated by policy mistakes.

Trade Wars and Tariffs

El-Erian notes that trade wars, which previously kept him up at night, are less of a concern now because the US has been able to impose higher tariffs without triggering significant retaliation. However, Lael Brainard and Anne Walsh suggest that tariffs are still contributing to inflation in specific sectors like baby clothes, strollers, toys, and furniture, and are a factor in the broader affordability crisis. Brainard also points out that tariffs are hurting coffee and bananas, though structural forces are also at play.

The Federal Reserve and Monetary Policy

A Divided Fed and the Next Chair

El-Erian describes the Federal Reserve as a "divided Fed" in 2026, split on two key issues:

1. Employment vs. Inflation Sensitivity: A division between those prioritizing the employment side of the dual mandate and those focusing on inflation. Both indicators are currently flashing yellow.
2. Backward-Looking vs. Forward-Looking: A division between those comfortable with being "data dependent" and those who recognize the need for a strategic, forward-looking view, especially concerning AI's impact on productivity and growth.

The new Fed chair will need to bring a "unifying narrative" that is forward-looking and includes a vision for the future economy.

Reforms and Independence

El-Erian believes the Fed "went to sleep" and requires significant reform. He advocates for:

• Revisiting the Inflation Target: He suggests changing the 2% point estimate to a range, perhaps 2.5% to 3%, arguing that a point estimate suggests elusive precision. He notes that current inflation is stable at 3% without unanchoring expectations.
• Targeting the Right Intermediate Policy Variable: Acknowledging internal Fed debate on this.
• Learning from Global Best Practices: Incorporating lessons from other central banks.
• Addressing Culture Issues: Referencing past irregularities involving Fed officials.

He believes political pressure has incentivized the Fed to reform from within rather than have reforms imposed.

The Role of AI in Monetary Policy

El-Erian is a "great believer in the promise of AI." He posits that if AI diffusion is managed correctly, it will lead to "significant productivity increase," allowing for "looser monetary policy than it would otherwise have been."

Attacks on the Fed and its Credibility

Both El-Erian and Lael Brainard express deep concern about unprecedented attacks on the Fed's independence, particularly from the Trump administration. Brainard highlights:

• Attempts to Fire Board Members: The unprecedented move to fire a board member without cause.
• Appointment of New Board Members: Appointing a new board member while they were still on the staff of the President's office.
• Pressure to Lower Rates: Statements suggesting the Fed should lower rates to reduce the national debt service cost, a direct violation of Fed independence.

Brainard emphasizes that Fed independence is "key to its credibility on inflation fighting" and anchors inflation expectations.

The Next Fed Chair Candidates

While not explicitly naming favorites, El-Erian mentions that all five candidates on the shortlist understand the importance of Fed independence and the need for reform. Anne Walsh, however, expresses a preference for candidates with an economist background, specifically mentioning Kevin Warsh (monetarist), Mickey Bowman, Kevin Hassett, and Chris Waller. She believes the next Fed chair will inherit a "more dovish Fed composition."

Rate Cut Debate

Lael Brainard, if still at the Fed, would argue for a rate cut in December, prioritizing the risk of a "self-reinforcing downturn in the business sector" and "real pain for American households" over the risk of tariffs pushing prices higher for longer. She believes the Fed is more concerned about downside risks to the labor market and is willing to take more risk on the inflation side. Anne Walsh also believes the Fed will cut in December, citing the Beige Book's indication of slowing and fraying economic edges, suggesting a lower neutral rate. She anticipates more rate cuts in 2026.

The "Bifurcated Economy" and Affordability Crisis

The Two-Speed Economy

Brainard and Walsh describe a "two-track" or "bifurcated economy." The AI sector and related industries (data centers, electricity, chips) are experiencing record interest and massive investment, but are not significant job creators. The rest of the economy is suffering due to less favor in capital markets, the impact of tariffs, and uncertainty about integrating AI. This leads to divergent economic experiences.

Affordability Concerns

Brainard highlights that lower and middle-income households are "really concerned about affordability." They see rising prices for everyday items like coffee and bananas, persistent housing costs, and increasing utility expenses. They also worry about job opportunities. This contrasts with the top 10% of consumers whose housing values and stock portfolios have increased.

Government Policy and Affordability

Brainard notes the administration's recent focus on bringing down prices for items like coffee and bananas, acknowledging that consumers are "really troubled by this affordability." She suggests that the administration can remove tariffs to help, but fundamentally reversing affordability crises in areas like housing and healthcare will be "very difficult."

AI and Market Valuations

The "Rational Bubble" in AI Stocks

El-Erian, working with Mike Spence, believes the market is in a "rational bubble" regarding AI stocks. This bubble has three elements:

1. Frontier Investment: Significant investment in foundational AI models, not all of which will succeed.
2. Diffusion Policy: A lack of a clear policy for diffusing AI into the workplace in an orderly and comprehensive manner, unlike countries like China and the UAE.
3. AI Labeling: Similar to the dot-com era, companies are using "AI" as a label to attract investment, even if their core business isn't fundamentally AI-driven.

Despite these bubble elements leading to potential losses for some, the "aggregate value of what's being created is significant." This justifies a venture capital approach to AI investment due to the large potential payoff.

AI's Impact on Jobs

El-Erian is concerned about the "corporate mindset" viewing AI primarily as a "cost minimizer" rather than a "productivity enabler." He fears that a focus on cost minimization could lead to labor displacement, whereas the "real promise of AI is not labor displacement, it's labor enhancement."

Investing in AI

Anne Walsh sees AI as a long-term technological game-changer but believes we are in the "early innings." Current investment is focused on infrastructure (chips, data centers, power). The broader application and usage of AI across the economy will take time. While she doesn't believe we are in a bubble comparable to the dot-com era due to existing earnings, she cautions about the potential for piling on debt for AI infrastructure buildout. She believes technology will continue to drive stock market performance.

Government Functionality and Political Risk

Government Shutdowns and Volatility

Anne Walsh views fiscal policy and political disruption, including government shutdowns, as a source of ongoing volatility for the Trump administration. While markets may become accustomed to some of this, the "political gulf in this country" is an "underappreciated risk." She separates markets from politics and policy, noting that markets are increasingly looking past headline narratives to Fed policy and fundamentals.

Trump Administration Policy Pillars

Walsh identifies four policy pillars of the Trump administration:

1. Trade and Tariffs: Continues to be a factor.
2. Deregulation: Ongoing in the background.
3. Tax Policy: Certainty provided by the "one big beautiful bill" is expected to create tailwinds into 2026.
4. Immigration Policy (Reverse Immigration): This is also playing out.

Credit Markets and Risk Assessment

Cyclical vs. Structural Risk in Credit

Walsh distinguishes between cyclical risk (late-cycle bankruptcies due to economic slowdown) and structural risk (overleveraging and weakened investor protections, as seen in the financial crisis). She believes current issues with companies like "ricolor" and "first brands" are more cyclical than structural, but she remains vigilant for signs of widespread structural risk.

Diligence in Lending

Walsh uses the analogy of a "Tiffany's box" filled with dirt instead of a diamond ring to emphasize the importance of lenders and investors conducting thorough due diligence. They must look beyond superficial appearances and understand the underlying value of their investments.

Conclusion and Policy Recommendations

A Message to Policymakers

El-Erian's key message to policymakers is to "realize that our future is going to be at the tails of distribution, not in the belly." He urges them to understand that we are living in a world of fragmentation and structural change, where outcomes at the extremes will be determinative. He advises against being fooled by a normal distribution and to recognize the "multimodal world."

Legacy of Jerome Powell

Lael Brainard believes Jerome Powell's most important legacy will be his "very determined efforts to guard the independence of the Federal Reserve," ensuring its institutional strength and resilience. This legacy is crucial for maintaining public confidence in low inflation without requiring high unemployment.

Federal Reserve's Neutral Rate and Future Policy

Anne Walsh believes the neutral rate is likely lower than currently perceived, closer to 3%, and that the Fed will continue to cut rates. She anticipates more rate cutting in 2026, supported by tailwinds from the "one big beautiful bill" and tax benefits. This outlook suggests a more neutral policy, keeping the economy out of recession but not overheating.

AI and Market Performance

Walsh remains positive on technology and AI in the long run, believing it will be a "technological game-changer." She sees continued market performance driven by technology, despite short-term valuation concerns.