According to economist Mohamed El-Erian, the Federal Reserve has made policy mistakes by acting too late to tame inflation, and then doing too little. Now El-Erian, chief economic advisor at Allianz, the German financial-services giant, and chair of Gramercy Funds Management, worries that central bankers have been left with bad choices that raise the risk of financial and economic accidents.
El-Erian has seen his share of accidents and near misses in a storied career. He has been deputy director at the International Monetary Fund, chief executive at fixed-income powerhouse Pimco, and CEO and president of Harvard Management Company, which oversees Harvard University’s endowment. After the 2008-09 financial crisis, he coined the term “new normal” to refer to the subsequent era of slow economic growth.
El-Erian spoke with Barron’s on March 27 from his office in Cambridge, England, where he is president of Queens’ College. He discussed the latest turmoil in banking, the geopolitical “regime change” that investors and companies need to accept, and why Fed Chairman Jerome Powell should take some advice from Hamilton. An edited version of the conversation follows.
Barron’s: As an economist and market watcher, what are you most worried about today?
Mohamed El-Erian: I’m more worried about economic contagion than financial contagion—namely, that the banking tremors we’ve had will lead to a reduction in credit to the economy over the course of this year and early next year, increasing the risk not just of recession but stagflation. We have the tools to contain the spread of financial instability, but I worry about credit contraction, in addition to the other headwinds facing the economy. That would make economic growth even more elusive and might result in a rolling credit crunch that impacts highly levered sectors of the economy the most. But it could spread even to simple lending.
How would that differ from the global financial crisis?
That was a crisis of payment and service systems, when banks didn’t trust each other. Financial intermediation stopped, and therefore, the real economy experienced a sudden stop.
This [banking turmoil] is very different. In terms of degree of severity, it is probably one-tenth of what we felt in 2008. Next you could see the first signs [of economic contagion] in restricted bank lending to the real economy by community and regional banks that have lost deposits. You would then see problems in small and medium-size businesses.
How does inflation impact the economic outlook?
Whether you look at the banking situation, the credit situation, or inflation, you come back to the common cause: an interest-rate cycle mishandled in several ways. First was mischaracterizing inflation as transitory for most of 2021. Even after the Fed admitted that inflation wasn’t transitory, it didn’t do anything about it and it continued pumping liquidity into the economy until March 2022, when inflation was already running about 7% on an annualized basis. The third mistake it made was that it didn’t reinforce its bank supervision to assess the impact of a very concentrated interest-rate hiking cycle.
It’s as if the Fed is driving down a foggy freeway. It makes the judgment that the fog is going to lift, so it sees no reason to slow down. Once it realizes the fog isn’t lifting but getting thicker, it continues with its pedal to the metal and then slams on the brakes. That sort of driving causes accidents—some financial accidents, and there is more worry about an economic accident.
What could these accidents look like?
We have yet to see a full restoration of trust, and we don’t know yet what is going to happen to the asset side of the banks. On the liability side, deposits became flightier. The concern is that the banks’ mishandling of interest-rate risk heightens credit risk.
Are you worried about risks lurking in private markets?
Whenever there are sharp movements in interest rates, we discover something. With Covid-19, we discovered the liability-driven investment problem in the United Kingdom, which almost closed down the pension system. We have discovered [strains in] commercial real estate. There are all these areas in the non-bank sector that we’re worried about that have escaped supervision and regulation.
What does this mean for investors?
In the past month, the two-year [Treasury] note has gone from yielding 5.08% to 3.58%, and is now back to 3.87%. That’s a [big swing] in just one month in something that is supposed to be anchored by the Fed. Over the past six months, the consensus forecast for the largest economy in the world went from a soft landing to a hard landing to a no landing to a hard landing.
There are two big divergences that need to be reconciled in the next few months: One is [what the] equity market is telling us versus what the bond and commodity markets are saying. The second is what the Fed is telling us about interest rates, versus what the markets are telling us about rates.
The bad news is that we are on a bumpy journey. The good news is that it’s a bumpy journey to a better destination.
You have been hawkish in terms of where the Fed needs to go with interest rates. How much further do they need to raise rates?
It’s tricky. Once you’re out of the world of first best, there are no good solutions. Everything you do has collateral damage and unintended consequences. This [response to inflation] will go down in history as one of the biggest policy mistakes by the Federal Reserve because it is no longer just an issue of inflation versus growth but now inflation versus growth versus financial stability.
The least-bad option now consists of holding off on interest-rate hikes and being honest with the market about where interest rates are going. The Fed needs to maintain consistent communication. Stock market volatility under this Fed on the day of the press conference after the Fed’s policy-committee meeting has been three times as high as it was under the previous Fed chair. That’s because [Powell] isn’t sticking to the script.
What do you advise?
Do you know the line from Hamilton? Talk less, smile more.
Is the Fed’s 2% inflation target too rigid?
By the end of the third quarter, this is what the Fed is going to face: With inflation sticking at 4% to 5%, do we stick to our 2% target and crush the economy [with more rate hikes], or recognize that we now live in a world of deficient aggregate supply and revisit the inflation policy?
Option three, the preferable option, is you try to trick the market. You continue to promise 2% inflation down the road, and you wait to see if 3% to 4% inflation is stable. Once 3% to 4% is stable, which I believe it will be, the Fed can adjust its inflation target.
Photograph by Kemka Ajoku
Why are we in a world of “deficient aggregate supply”?
Reason No. 1 is a change in globalization with near-shoring or friend-shoring, a geopolitically driven rewiring of supply chains. Companies also want to diversify their supply chains—“just in time” has given way to “just in case.” Resilience has become a driving force. That’s a multiyear effort—and inflationary. The third issue is the energy transition, which is inherently inflationary, and then there’s the functioning of the labor market, and the shortage of workers.
China is a central character in this rewiring, and there’s also a lot of concern about its economy. What’s your outlook?
The best days of the Chinese economy are behind us. Even when it recovers from the government’s zero-Covid policy, it doesn’t have the engines to produce 5% to 6% growth sustainably because its major engine—the global economy—is no longer that potent. China needs to accelerate internal transitions, which should need less state control. Instead we’re seeing the state intervene in more sectors.
What does that mean for corporate strategy and investor allocations?
As China delivered this domestic economic miracle, [companies] invested in China to serve China and the rest of the world. Now, with nationalism, it is increasingly in China, for China, by China. [U.S. multinationals] want to look more like Chinese companies because they want to protect not only against tariffs when supplying the outside world, but also against nationalism.
How significant is the shift in the U.S./China relationship?
It’s a multidecade regime change. If you are going to invest heavily in China, you are taking a national security view as much as an economic view. People aren’t doing that.
What does this mean for the rest of the emerging world?
It is an opportunity. You have countries that are readily able to absorb the supply chains, Vietnam being an example, but they reach capacity limits quickly. Then you have companies that are a natural destination for supply chains, but need to get things done first. Mexico needs to deal with its energy issues to be able to attract the supply chains leaving China. It needs to make its energy policy less environmentally problematic. And then there are countries that aren’t the natural recipients of [business from companies looking to diversify supply chains], but are making themselves so. Jordan, for instance, is starting to make inroads in textiles and footwear.
What else should investors consider as these shifts occur?
In a world with a lot of differentiation, index investing in certain asset classes, such as high-yield bonds or emerging markets, is dangerous. I learned that lesson when I first joined Pimco from the IMF. Argentina was 20% of the emerging markets index in 1999 because it had issued so much debt.
The conventional wisdom—which I understood in a world of growing liquidity where all boats rise—was that you should index because that’s the low-cost approach. Today that will be true only for the most liquid asset classes that aren’t subject to default.
Thank you, Mohamed.
Write to Reshma Kapadia at [email protected]
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