The worst thing the Federal Reserve can do now is cut interest rates, top economist Mohamed El-Erian says

• The worst thing the Fed could do now is cut rates, according to top economist Mohamed El-Erian.
• Cutting rates to ease banking stress could lead to stagflation and financial instability, he warned.

Markets have been upping bets that the Federal Reserve will cut interest rates as soon as this summer as the economy deals with stress from the banking crisis, but that's actually the worst thing the central could do at this point, according to top economist Mohamed El-Erian.

"The worst thing they could do right now is say, we have a credit issue coming, let's cut interest rates," the Allianz chief economic advisor said in an interview with Bloomberg on Monday. "If they do that, we could end up with stagflation and financial instability."

El-Erian has warned of a potential stagflationary crisis and growing financial instability for months, as prices are still well-above the Fed's 2% inflation target, and the market has taken a dim view of the central bank's ability to rein it in without hurting the economy. Cutting interest rates would damage that trust even further, he said, and ups the risk that inflation expectations spiral out of control.

And despite recent banking turmoil stemming from the collapse of Silicon Valley Bank, it would be a mistake to dial back rates to ease banking stress. El-Erian pointed to recent comments from European Central Bank President Christine Lagarde, who said interest rates are primarily a monetary policy tool to control inflation, as there are other policy tools used to control financial stability.

But markets are already expecting banking stress to drive lower interest rates later this year, with investors pricing in a final 25 basis-point rate hike in May, followed by a 25 basis-point rate cut in June, according to the CME FedWatch tool.

"The reason why the market thinks that we're going to get a cut as early as June is because they believe that the Fed is not going to be reacting not to a significant decline in core inflation – that's going to be a problem – but it's going to be reacting to something else. And I think that would be a mistake," El-Erian said, adding that in his view, the Fed shouldn't be cutting interest rates this year at all.

Interest rates are the highest they've been since 2007, with the Fed funds rate falling between a range of 4.75-5%. Central bankers were forced to raise interest rates aggressively last year to tame inflation, as they mistakenly brushed off rising prices as "transitory" in 2021, causing them to tighten monetary policy too later.

El-Erian compared the Fed's policy to driving in fog at maximum speed, before suddenly slamming the brakes.

"Do we expect accidents when someone drives like that? Yes. And we do, we've gotten financial accidents. To me, this doesn't come as a surprise at all," he said. "The hope is we don't get a big economic accident."