The Fed could make major mistake this September, says influential economist

The Federal Reserve’s decision to cut interest rates should be easy, but policymakers’ “current mindset” has complicated matters, according to Queens College president Mohamed El-Erian.

In a Bloomberg op-ed, El-Erian said inflation is no longer a threat to the U.S. economy after the Consumer Price Index (CPI) fell from a peak of 9.1% in mid-2022 to the current rate of 3%.

Moving forward, most economists expect CPI to settle in the 2.5% to 3% range,

Under normal circumstances, this would “open the window for the central bank to cut interest rates,” but what El-Erian calls the Fed’s “current mindset” has limited what policymakers can do.

“Failing to ease policy in either July or September—an outcome that unfortunately can’t be ruled out—would constitute another policy mistake for a Fed seeking to restore its credibility after fumbling the initial response to building price pressures in 2021,” El-Erian wrote.

Fed officials have opted to keep rates higher until inflation falls back to the 2% target. El-Erian thinks this is a foolish approach and has called on policymakers to abandon that "arbitrary" inflation target.

Although higher rates could help the Fed slay the inflation dragon once and for all, it’ll come at a huge cost of “causing undue damage to employment and the economy,” he wrote.

So far, the U.S. has dodged the nasty downturn that El-Erian is worried about, but how long the economy can withstand higher rates is yet to be seen.

Higher rates take their toll

Stephanie Hoopes, an executive at the United Way, told CNBC that “keeping rates high is hurting the labor market and ALICEs’ ability to have higher wages.”

ALICE refers to Americans who are "asset limited," "income constrained," and "employed"—a category that includes 40 million families, or nearly a third of the U.S. population.

Small businesses are also struggling to grow their revenue in a high-interest-rate environment. Research from the Minneapolis Fed showed that the combination of high prices and elevated interest rates has been a major drag on business revenue.

A recent Minneapolis Fed survey of 602 businesses across Minnesota revealed that companies reported “both lower revenues and profits, and some noticed their customers reducing spending.”

Although U.S. GDP expanded faster than expected in the second quarter, that's mainly the result of Americans dipping into savings, the government running up deficits, and inventories building up, according to economist David Rosenberg.

Meanwhile, the services sector—a horsepower of the U.S. economy—contracted at the end of the second quarter.

The Institute for Supply Management’s services purchasing managers index (PMI) fell from 53.8% in May to 48.8% in June, on a scale where anything below 50 indicates a decline in economic activity.

It was the biggest drop in four years.