El-Erian issues an important reminder about the Fed and the US economy

Armed with one of the most powerful levers to steer the US economy, even the Fed can’t solve this economic crisis. Alone, anyway.

As inflation and bond yields continue to crest — squeezing consumers, shining a spotlight on affordability issues, and amplifying the magnitude of government debt — we’ve been consistently looking to the Fed for both diagnosis and cure.

But we’re asking too much of the central bank.

With some positive inflation news and a surprising sign of a cooling labor market, Fed palace intrigue is dominating the conversation. And for good reason, as Chairman Kevin Warsh has said, the Fed is incredibly powerful. But there are limits to what it can reasonably do.

That’s what Mohamed El-Erian, chief economic adviser at Allianz, reminded us on Friday as the market reinterpreted rate-setting bets: The Fed’s important — but fiscal policy matters too. 

We may still expect a series of hikes to come — these things usually come in groups — but stepping back, a few things are obvious beyond the fact that the Fed can’t cancel a war and unblock an oil choke point. (Rate expectations drastically shifted from a week ago, where an October hike was a likelihood. As of Friday afternoon, there’s an almost 80% probability the Fed holds rates steady.) 

“Monetary policy should not be the only game in town,” El-Erian said on Yahoo Finance’s live morning show The 8:30. “This is a role for fiscal policy.”

Chief among the problems ill-suited for the Fed to handle is the deficit. Central bankers don’t control government spending, but it’s a critical part of the bond yield dilemma. Though the Fed is consistently called to fix the collapsing bond market and its rising yields, Washington’s inability (or disinterest) to pull back spending deserves just as much attention.

Considering the economy’s relative strength, with unemployment at 4.2% (though it might not feel that way for job seekers), El-Erian described running a 6% of GDP deficit as “ridiculous” amid such boom times.

And it’s not just that the Fed can’t magically shrink spending or boost tax revenue. El-Erian argued that the Fed’s tools for addressing the consequences of higher government debt can exacerbate economic problems. 

“I worry that we’re going to get too much monetary, too many hikes, too few fiscal policy measures. And then we’re going to have to deal with this very uneven economy and an even more pronounced K,” he said, highlighting the shape of the economy where the “haves” fortunes surge while the “have nots” fall.

When the only move is to raise interest rates, and monetary policy attempts to carry too much of the burden, he said, less affluent Americans feel the crunch. “You overly sacrifice the housing market and the car loan market, which impacts, of course, the lower-income households.”

The lack of direction from the Treasury and from Congress goes to the core of the problem that’s driven up interest rates — from the uncertainty over the future of oil flows, disjointed AI policy, and shortsighted approaches to taxing and spending. 

Across two chairs, the entirety of the Jerome Powell era, and now at the start of Kevin Warsh’s, policymakers and investors have looked to the Fed to fix intractable problems that don’t fit neatly under the central bank’s mandate. Wall Street and, to a certain extent, the White House are leaning on Fed decisions to unwind dilemmas it was never built to solve.

No rate decision can fix the debt, the spending, or the Iran conflict. Yet markets hang on the Fed’s every move as if it were a silver bullet.

Hamza Shaban is a Senior Writer for Yahoo Finance covering markets and the economy. Follow Hamza on X @hshaban.

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