This article was written by Mohamed El-Erian, the chief economic advisor at Allianz and the Dean of Queens' College, Cambridge University.

Markets and economists generally believe that the Federal Reserve will cut rates at this week's policy meeting. At the same time, it is also expected that this will be accompanied by forward guidance, implying fewer rate cuts in 2025 than previously anticipated, a higher terminal rate, and a pause in January of next year. Besides, many things will largely depend on how the Federal Reserve's view on inflation evolves, as inflation has persistently remained above its 2% target.

Market expectations for a 0.25 percentage point reduction in the federal funds rate this week exceed 90%. Although there are discrepancies in predictions among officials, it is expected that they will still outline a higher rate path in the 'dot plot' and that the terminal rate will be closer to market expectations.

Lastly, while Federal Reserve Chairman Powell is not expected to completely abandon all policy options for January, he is anticipated to signal at the press conference that the Federal Reserve will maintain the status quo when the Federal Open Market Committee (FOMC) meets next month.

The situation after January of next year has become an interesting topic of debate. Many anticipate that after a 'skip' of one rate cut, easing policies will resume, continuing with rate cuts at a quarterly pace throughout 2025. Others are more inclined to see it as a 'pause' in rate cuts, holding greater uncertainty about subsequent cuts. At least for now, very few believe that this week's rate cut could be the end of the current easing cycle.

Different assessments regarding inflation, economic conditions, and the policy intentions of the incoming government explain the diversity of these opinions. Moreover, a divergence of about 75 basis points has emerged between the Federal Reserve's easing path for 2024 and the market consensus from a year ago, which has also played a role.

Last week's inflation data showed that the process of returning to the Federal Reserve's 2% target has now become more hesitant, a phenomenon pointed out by a few for some time. The report released last week indicated that consumer prices (CPI), excluding volatile food and energy costs, rose 0.3% month-on-month for the fourth consecutive month. The producer price index report released the next day was hotter than expected. The components of these two reports suggest that the core personal consumption expenditure index (PCE) is unable to quickly reach 2%.

It is worth noting that this data aligns with a series of positive surprises from reports related to economic activity. Although few are eager to confidently estimate the specific impacts of President-elect Trump's policies, most believe that a combination of higher tariffs, immigration restrictions, deportation measures, and fiscal pressures could bring inflation effects before significant deregulation and liberalization yield supply-side benefits. After all, we also have signs indicating that liquidity conditions are quite loose.

In this scenario, the Federal Reserve will soon be forced to face an important policy choice that impacts the sustainability of American economic exceptionalism and the health of the stock market.

Should the Federal Reserve implicitly and explicitly reaffirm its 2% inflation target and double down on efforts to bring the economy to this target? Powell stated last month, 'We will not speculate, we will not assume, or hypothesize' the policies of the new administration. Sticking to the current target will still involve the Federal Reserve implementing a relatively 'hawkish' rate cut early Thursday morning. In closed-door meetings, future rate cut thoughts will shift from 'We can continue to cut rates because it is only a matter of time before inflation reaches our target' to 'We need to maintain the policy tightening for much longer than expected.' In fact, in this situation, a complete policy reversal, including rate hikes, is not entirely impossible.

Otherwise, should it implicitly acknowledge that, due to various ongoing structural changes both domestically and internationally, the equilibrium inflation rate of the economy has risen? If the U.S. economy can operate with an inflation rate close to 3% without negatively affecting expectations (or harming growth prospects), then the more the Federal Reserve tries to force the economy to strictly achieve a 2% inflation level, the greater the threat to American economic exceptionalism, the stock market, and financial stability.

It should be clarified that the second scenario does not imply that the Federal Reserve will publicly abandon its inflation target and shift to a new range of 2.5%-3%. Given its failure to meet the target over the past three years, this situation is unlikely to happen. Instead, in public statements, the Federal Reserve will only continue to delay the timeline for achieving the current target. In closed-door meetings, however, policies will be implemented according to a de facto higher target. How long this status will last partly depends on the government's progress in enhancing productivity, supply-side policies, corporate pricing strategies, and the development of the global economy.

In response to what I believe may be an inevitable decision point, the Federal Reserve must change the way it formulates policy. It needs to shift from an over-reliance on historical data to a more strategic, forward-looking approach. The outcome of its choices will have significant implications for economic growth as well as market valuations and volatility—not only in the United States but globally.

Article reposted from: Jinshi Data