Inside the Fed's 'hall of mirrors' problem

New York(CNN Business) The Federal Reserve has allowed itself to get backed into a corner by Wall Street. That means the central bank may need to slash interest rates — even if it doesn't want to.

Markets believe a rate cut later this month is a slam dunk, and the Fed has done little to push back against that thinking. Keeping rates steady would create a market shock — one that could infect the real economy by denting confidence.

"We're in an environment where confidence is weak. This isn't a good time to be shocking the markets," Ethan Harris, head of global economics at Bank of America Merrill Lynch, told CNN Business.

Even though Wall Street is pricing in a 100% chance of a July rate cut, Harris believes the real odds are 50/50 — essentially a "gameday decision."

"It is a big mistake for the Fed not to push back against the markets," Harris said.

Central banks are supposed to set policy for markets, not the other way around. It's never a good idea to let the inmates run the asylum.

Yet Goldman Sachs chief economist Jan Hatzius said in a report on Monday that "bond market pricing may be playing a bigger role in driving policy decisions than in the past."

He cited the "cost of not delivering on near-term policy expectations" — meaning the wave of selling that failing to cut rates would set off.

'Policy mistake'

The stock market's recent surge back to all-time highs has been driven at least in part by the widespread belief that the Fed is cutting rates. That's why stocks have retreated since Friday's strong jobs report, which dashed hopes of an even deeper rate cut in July than is currently expected.

Goldman Sachs said that while there are some advantages to relying on the "wisdom of the crowds," there are significant downsides.

"It also raises the risk that monetary policy ... takes the fund rate far away from the level justified by economic fundamentals," Hatzius wrote.

He noted that former Fed chief Ben Bernanke warned in a 2004 speech that focusing too much on meeting market expectations can disorient central bankers.

"Such a strategy quickly degenerates into a hall of mirrors," Bernanke, then a Fed governor, said in the speech.

Bank of America's Harris urged Fed chief Jerome Powell to use his appearance on Wednesday and Thursday before lawmakers as an opportunity to reset market expectations.

"Neutral testimony from the Fed that doesn't address this mispricing would be a policy mistake," Harris said. "If they go into the meeting with the market fully convinced they will cut, they will only have bad choices."

For now, most market observers are betting the Fed will accede to Wall Street's calls for lower rates.

"While there is always the risk that the Fed will not get as accommodative as the market hopes for, it will likely err on the side of giving the market what it needs," Kristina Hooper, chief global market strategist at Invesco, wrote in a report on Monday.

Strong jobs report

Economists generally agree that the US economy is decelerating from a period of strong growth. But there is broad disagreement over just how severe the slowdown is — and whether it merits rate cuts from the Fed.

The picture was further muddied by the robust June jobs report, which showed the United States added 224,000 jobs.

"We don't see a good justification for a rate cut right now," Ed Yardeni, president of investment advisory Yardeni Research, wrote to clients on Tuesday.

At least one Fed official agrees.

Philadelphia Fed President Patrick Harker told The Wall Street Journal in an interview published on Tuesday that he doesn't see a compelling reason to lower rates.

Yardeni went a step further, saying that it would be a "mistake" for the Fed to proceed with a quarter-point rate cut.

One risk is that easier money inflates an asset bubble that eventually implodes. Low rates paved the way for the dotcom bubble of the late 1990s and the housing boom of last decade.

"The Fed doesn't have much ammo left and should save it for when it is really necessary to use," Yardeni wrote.

What if inflation reheats?

And then there's the inflation issue. Inflation has decelerated in recent months, freeing the Fed to lower rates to boost inflation. However, it's possible that inflation could reawaken due to the US-China trade war.

The net percent of small business owners raising their average selling price rose sharply in June, according to the NFIB Small Business Optimism Index published on Tuesday.

Adjusted for the impact of gas prices, which dipped last month, the selling price measure rose to the highest level since November 2006, according to a report by Ian Shepherd, chief economist at Pantheon Macroeconomics.

Shepherd attributed the jump to the increase in tariffs on Chinese imports in May, from 10% to 25%. And he said that if sustained, it's consistent with core consumer price inflation rising to the highest levels of the economic cycle over the next year.

Of course, warming inflation typically calls for rate hikes, not cuts.