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Pimco's McCulley: Yellen facing big challenge

The Federal Reserve wants to raise interest rates, but Fed Chair Janet Yellen has a big challenge ahead in how she communicates the central bank's decision, Pimco's chief economist Paul McCulley told CNBC Thursday.

"I think the economy is improving in a very meaningful sort of way, and I think the Fed wants to get off of zero," McCulley said.

"Getting off of zero is not saying they are behind the curve, it's not saying we have an inflation problem, it is simply declaring victory on getting out of the liquidity trap and that's a very delicate communication strategy."

The Fed is scheduled to meet next week, and odds are increasing that it will drop a key phrase in its statement that says there will be "considerable time" from the end of the Fed's bond purchase to the first rate hike. Investors could see that as an indication that rate hikes are coming sooner than expected.

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Paul McCulley, chief economist of Pimco, is shown at the firm's headquarters in Newport Beach, Calif.
Patrick T. Fallon | Bloomberg | Getty Images
Paul McCulley, chief economist of Pimco, is shown at the firm's headquarters in Newport Beach, Calif.

McCulley said that phrase is one of two that must be removed before rates can be increased. The other is that there is "substantial under-utilization of labor resources."

"Those are the phrases that the marketplace is just pinned right to the wall on," he said. "The marketplace is telescoping forward the hike based upon the change of language that's potential at any time on those two phrases in the next number of FOMC meetings."

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Both the hawks and the doves on the committee have criticized the language. McCulley said that is because it is connected to the calendar, and they want to move to data dependency.

"The real issue becomes are you a hawk or a dove. How do you look at the data and how do you measure resource utilization and also quite frankly when do you want to induce a correction in risk assets, which is a significant probability once you change that language," he said.

With a strong dollar and the global environment "darkening" in recent months, the Fed also finds itself in a "risk management paradigm."

"The risk associated with getting off of zero is higher if you are doing so in context of a weaker global economy and a stronger currency."

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The best scenario for the markets is if the central bank can raise rates for the overnight rate, but without moving the five-year/five-year forward rate very much, McCulley said.

"Then I think that you can have a pretty mild correction in both bonds and the equity markets," he predicted.

—By CNBC's Michelle Fox