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'Substantial risk' that Fed is about to make a serious mistake, Pimco advisor says

Key Points
  • Joachim Fels at Pimco said the Fed shouldn't be raising rates with the evidence so clear that it is falling well short of its inflation mandate.
  • Fels said the economy is "only one major adverse shock away from a serious deflationary scare. "
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For years, the Fed faced criticism that it wasn't being aggressive enough in raising rates. Now that it has started to hike, the central bank is under increasing fire for moving too soon.

The latest scrutiny comes from Joachim Fels, global economic advisor at Fed bond giant Pimco, who said the Fed shouldn't be tightening policy with the evidence so clear that it is falling well short of its inflation mandate.

Fels' argument: Much like the position that waiting so long to raise rates would give the Fed little ammunition to use against a downturn, hiking now will keep inflation too low and possibly itself lead to another slowdown or recession.

Fed officials have said they believe the economy is sufficiently strong to handle rate increases and presents the opportunity to start normalizing policy after years of historically accommodative actions.

"The prize of opportunistic tightening comes at a price: By hiking rates and starting balance-sheet runoff when inflation keeps undershooting, the Fed risks cementing inflation expectations firmly below target," Fels wrote in a blog post for Pimco.

"Some argue that this is a price worth paying. After all, does it really matter whether inflation is running at 2 percent or 1.5 percent or 1 percent?" he added. "Well, the difference doesn't really matter until it does."

Janet Yellen, chair of the U.S. Federal Reserve, speaks during a news conference following a Federal Open Market Committee (FOMC) meeting in Washington, D.C., U.S., on Wednesday, June 14, 2017.
Andrew Harrer | Bloomberg | Getty Images

Fels joins a growing crowd that believes the Fed, with inflation tracking only around 1.5 percent, is needlessly risking a recession by tightening policy. Supporters of the hikes see them as getting the Fed back to normal after years of ultra-easy policy that saw the central bank cut its benchmark target rate to near zero and explode its balance sheet to $4.5 trillion in economic stimulus.

Most recently, prominent economists with a group called "Fed Up," including former Minneapolis Fed President Narayana Kocherlakota, publicly criticized the Fed and said it should raise its inflation target from the current 2 percent level.

Similarly, Fels sees central bank officials being too vigilant against an inflation problem that doesn't currently exist.

"While the economic expansion continues, below-target inflation is not a major problem," he said. "However — and this is the catch — when the next downturn hits, there won't be much of an inflation safety margin against deflation."

The current low inflation rate at a time when the economy is near or ahead of full employment means "we are only one major adverse shock away from a serious deflationary scare," Fels added.

"That's why there is substantial risk that the Fed's opportunistic tightening campaign is a hawkish mistake," he said.

Watch: Economist David Rosenberg says the markets have yet to feel the impact of the Fed's rate hikes.

We haven't seen full effect of Fed rate hikes: David Rosenburg