Monday’s global stock sell-off shook many professional investors, Wall Street leaders, and economists.
Take Wharton Professor Jeremy Siegel: The veteran stock watcher was quick to call for an emergency rate cut as stocks tumbled Monday morning, arguing the economy is slowing and inflation is essentially defeated, meaning the Federal Reserve is behind the curve once again.
“If they’re going to be as slow on the way down as they were on the way up—which, by the way, was the worst policy error in 50 years—then we’re not in for a good time with this economy,” Siegel said, referencing the Fed’s now-infamous “transitory” inflation call and decision to delay rate hikes in 2021.
Pershing Square Capital Management’s Bill Ackman took to X (formerly Twitter) to echo that message on Monday. “The Federal Reserve was too slow to raise rates. Now it is too slow to lower them,” he wrote. At one point during the heat of the sell-off, bond traders even began to believe an emergency rate cut was on the way, pricing in a 60% chance of an intermeeting rate cut.
But Mohamed El-Erian, president of Queens’ College at the University of Cambridge, said he doesn’t understand the logic behind the calls for an emergency, or intermeeting, rate cut.
“I strongly oppose this notion of an intermeeting cut. That would be a huge mistake,” he told Fortune. “I think it’s a little bit like wanting to go to the emergency room for a cough.”
A ‘policy overreaction’
El-Erian argued that there would be two main issues if the Fed were to implement an emergency rate cut.
“One is it will inadvertently undermine expectations—it risks making people more cautious, and companies more cautious, and credit providers more cautious,” he said.
The former PIMCO CEO explained that when the Fed opts for an emergency rate cut, it can spook business leaders, Wall Street analysts, and more.
“Because immediately the question is going to be: ‘why is the Fed doing this? We simply got a slightly weaker employment report. It wasn’t bad, it was weaker. There must be something else. There must be something in markets that has scared the Fed,” he said, doing a bit of Wall Street roleplay.
“The Fed is not going to be able to convince people that there isn’t something that they don’t know,” he added.
This undermining of expectations could even contribute to a recession, El Erian told Yahoo Finance Monday, because when people become increasingly worried about the economy due to a panicking Fed, they spend less, creating a “self-reinforcing negative spiral.”
But the veteran economist told Fortune that he still currently sees only a 35% chance of a U.S. recession over the next twelve months—that’s above the 15% norm, but not extreme.
Fed shouldn’t bail out jittery markets
The second reason to avoid an emergency rate cut, in El-Erian’s view, is the “moral hazard” of the Fed put—the idea that whenever markets fall, Fed officials will rush to save them with rate cuts.
“Markets were functioning fine yesterday. There was no breakage in market functioning. What people didn’t like was the volatility. But as long as the market is functioning fine, then the Fed should allow the market to clear itself,” he argued. “Otherwise, it feeds into the moral hazard of markets—that, don’t worry, the Fed will always come in to counter volatility.”
El-Erian expanded on his take in a Bloomberg op-ed on Tuesday, explaining that although he called for the Fed to cut rates in July, and he still believes not doing so was an error, emergency cuts “would constitute a policy overreaction” and officials shouldn’t led themselves be “bullied” into this move by investors.
That call now seems quite prescient, with stocks recovering on Tuesday. The Dow Jones Industrial Average rose 1.8% by 2:45 pm ET, while the S&P 500 and the tech-heavy Nasdaq Composite jumped 2.4% and 2.5%, respectively. Japan’s stock market, after falling more than 12% on its worst day since 1987 on Monday, also managed to recover most of its losses Tuesday, rising 10.23%.
The quick turnaround is likely due to the varied and complex reasons behind Monday’s global stock market rout. Although fears of a Fed policy error and potential economic slowdown or even recession did help spark the crash: “The sharp sell-off in risk assets was overdone relative to the current health of the U.S. economy, which is not on the precipice of a recession,” as Nationwide chief economist Kathy Bostjancic put it in emailed comments to Fortune.
El-Erian explained that there were also a few crowded trades that were “caught offside by the sudden change in both the economic and policy narratives.”
“This squeeze was further amplified by concerns of a Japanese-related deleveraging and sky-high valuations in certain segments of the market such as technology stocks,” he told Bloomberg.
Emergency Fed rate cuts are typically reserved for more serious and systemic issues, including major recessions, pandemics, or far more severe market declines.
However, El-Erian did argue that, moving forward, the Fed should be more strategic with its guidance, adding a forward-looking component in order to assuage markets’ fears that the central bank is, once again, lagging behind the reality on the ground. And while it will be important for the Fed to begin cutting rates in September, El-Erian said that the size of the rate cut is less relevant than the Fed’s messaging leading up to it.
“[Powell] has to regain authority, and he has to make forward policy guidance more meaningful,” he said.
“You know, I have been in this business for a long time, and I’ve never seen so many pivots in the Feds forward policy guidance. And the reason why is because they’ve become excessively data dependent, so they end up amplifying volatility rather than providing a strategic anchor to the economy and to markets,” he added.
An emergency rate cut demands a real emergency
Looking back at history, Monday’s global stock market rout doesn’t look likely to trigger an emergency Fed rate cut, either.
Bank of America’s head of U.S. economics, Michael Gapen, dug through the record books and found that there have been nine emergency Fed rate cuts since 1987—if you include the Fed’s response to the Black Monday stock market crash, “when the funds rate was not the principal tool of policy,” the BofA economist explained.
Two of these emergency cuts came in 2020, during the onset of the COVID pandemic, and two were in response to the global financial crisis in 2008. The Fed also implemented three emergency rate cuts in 2001—two after the dot-com bubble burst and another after 9/11.
In 1998, the Fed responded to the collapse of long term capital management and Russia’s financial crisis with an emergency cut as well. And finally, in 1987, the Black Monday stock market crash, when the S&P 500 lost more than 20% in a single day, also sparked emergency Fed action.
“History suggests the bar for intermeeting cuts is extremely high and that conditions on the ground today do not warrant such action,” Gapen wrote after dissecting this history in a Tuesday note seen by Fortune.
“Could we get there? Sure…we cannot predict the future and our view on the fundamental health of the economy and vibrancy of financial markets may be misplaced,” he added. “But if the question is, ‘should the Fed consider an intermeeting cut now?’, we think history says, ‘no, not even close.’”
El-Erian echoed this view, arguing that Monday’s market sell-off was “nowhere near” the severity of past events that triggered a quick shift in Fed policy.
Still, the chances of an intermeeting cut are not zero, particularly if markets take another leg down, given current Fed officials’ history.
“I put the chances of that happening at 10%,” El-Erian said. “Why not lower than that? Because this Fed has already been bullied by markets once. If you remember, the fourth quarter of 2018 markets got very volatile and the Fed did a U-turn on its policies, even though the economy didn’t need a U-turn.”
