El-Erian: ‘It’s uncomfortably possible’ that the Fed will push the economy into a recession

Queens College Cambridge President Mohamed El-Erian joins Yahoo Finance Live to discuss recessionary risks, inflation, volatility, energy futures, supply chain woes, and the outlook for Fed policy.

Video Transcript

- So we've been looking at all of the market action, part of it in reaction to what we heard from Jay Powell yesterday. Today's day two of Fed Chair Jerome Powell on Capitol Hill. This time, he'll be speaking in front of the House Financial Services Committee.

And I want to bring in Queens College Cambridge University President Mohamed El-Erian to discuss the Fed's latest move. Mohamed, before we dive into this, I want to play a little sound from yesterday's testimony, and actually not from Jay Powell, but from Senator Elizabeth Warren. Listen to what she said.

ELIZABETH WARREN: The Fed has no control over the main drivers of rising prices, but the Fed can slow demand by getting a lot of people fired and making families poorer. And while President Biden is working to increase energy supplies and straighten out supply chain kinks and break up monopolies and bring down prices, you could actually tip this economy into recession. So I just want to say, you know what's worse than high inflation and low unemployment? It's high inflation and a recession with millions of people out of work. And I hope you'll reconsider that as you drive this-- before you drive this economy off a cliff.

- So Mohamed, Elizabeth Warren kind of painting the worst-case scenario there. I mean, Larry Summers has talked about 5% unemployment in the US as a result of this cycle. Do you think that's where we're headed?

MOHAMED EL-ERIAN: So I do worry that the probability of a soft landing, which means you bring down inflation without unduly hurting growth and employment, that that probability has declined significantly because of a series of Federal Reserve mistakes. Senator Warren is correct in saying that the initial inflationary shock was external, something that the Fed couldn't do much about, but the Fed didn't recognize it had an inflation problem and didn't respond fast enough. And in the process, it has lost its credibility. So it is, unfortunately, uncomfortably possible that the Fed is going to slam on the brakes and push us into recession.

- And Mohamed, I want to linger on the credibility issue for just a moment. This is something you've talked about before. This is something now that is-- a lot more people are adopting as their view, that not just the Fed, but central banks globally have lost some credibility. Why is this such an important issue? You're really good at explaining these kinds of things. Why does it matter that central banks have lost credibility?

MOHAMED EL-ERIAN: Because of what's called forward policy guidance. The Fed tells you what it intends to do. It shows you what will result. And then it allows everybody to work together, all consistent with a certain journey and a certain destination. That is a Fed with high credibility. A Fed with low credibility, which is what we have today, people immediately question the Fed's projections, as happened last week. People called them unrealistic, called them other things.

Secondly, the market runs ahead of the Fed, tightens ahead of the Fed, now is loosening ahead of the Fed. Just look what's been happening in terms of volatility in the two-year treasury, where the Fed has most influence. So instead of the Fed leading the marketplace, the marketplace is dragging the Fed along. And the Fed is consistently late. And third, you take away the first policy response, which means that you end up with a worse outcome than you would have been otherwise. That is why central bank credibility is so important.

- Mohamed, one thing that the Fed doesn't have control over is the supply chain. Doesn't necessarily have control over energy, as well. And you've been posting about this even this morning on a more macro level, as well. And energy prices' role, particularly, not just in a US potential recession, but also in a global pullback, something that you've been talking about is the long-term oil supply shortages Europe could face, calling it the biggest risk factor to growth. Do you think that global growth projections are accurate as they stand right now, or should we see even more of a drawback on some of those projections?

MOHAMED EL-ERIAN: That's a great question. Not just should, we will see growth projections coming down more. We got some pretty awful PMI numbers out of Europe. The three biggest areas in the world are all slowing simultaneously-- China, the US and Europe. And what you're seeing in the oil market tells you that demand is now in control. For a long time, supply was in control of the oil market, and that drove prices higher and higher. Now, it is demand. And as people worry about a global slowdown, they worry about demand for oil, and oil prices have been coming down.

Europe has another problem, Brad, which is gas supplies from Russia and the possibility that that may stop overnight. And if that happens, it certainly throws Germany and the rest of Europe into recession. But that is related not to general economic conditions, it is related to the war in Ukraine.

- So I'm reminded of a conversation I had yesterday with an e-commerce entrepreneur, who said, economically, at least here in the US, things are certainly going to get worse before they get better. And what you're describing over in Europe with that natural gas scenario is sort of a worst-case scenario. So I guess, if you can, paint a picture for us globally economically. What are we in for here? What's the worst-case scenario, and what's the likelihood of that scenario coming to pass?

MOHAMED EL-ERIAN: So Julie, you know that I like distributions of potential outcomes. So think of the distributions of potential outcome. The baseline is stagflation, what we are experiencing now-- inflation high, growth slowing down. That is the baseline. Then think of the two tails of the distribution. The left tail, the bad tail, is recession. The right tail, the good tail, is high growth, low inflation.

The balance of risk has shifted significantly in favor of the left tail, recession. So you have a baseline that's not very comfortable, stagflation, and then you have a balance of risk which is the wrong way, recession. And that's why you get a sense, especially among companies who first had to deal with higher costs. Now the ability to pass through those higher costs into higher prices is being questioned by declining demand. And that's why they are nervous. And that's why you heard what you heard yesterday from the CEO. And you'll hear them from most CEOs.

- You know, the fact that you're saying stagflation is the baseline sort of throws into relief something that we've been hearing as a refrain from President Biden, from Powell himself, that we have a very solid economic footing right now. Is that obtuse for them to be making these kinds of comments while we are seeing the indicators that we're seeing?

MOHAMED EL-ERIAN: So if you go from the global economy to different countries, within the Western economies, the US is best placed. And the reason why the US is the best placed is the labor market. We have an incredibly solid labor market. Is it perfect? No.

I and many others would like to see higher labor force participation and would like to see wages not being eaten up by inflation as they are right now. But it's a pretty solid labor market. And you saw the latest jobs number. We still have over 10 million vacancies, twice the amount of unemployed. So that gives you some comfort that there's a backstop.

But remember, spending is not just a function of your income. Spending is a function of the expectation of your income. And the more people worry about a slowdown, the more they'll start pulling back on spending. They're already pulling back on certain spending because of high fuel and food prices. And the last thing we want is them to pull back continuously, because at that point, demand gets decoupled from the labor market. The labor market stays strong, but it doesn't get reflected in actual demand.

- Mohamed, would love to get your take on the cryptocurrency landscape at this point in time, too, knowing that, during the last crypto winter, you also had bought some Bitcoin, buying into that like 3,000 level, and saw that run up to 19,000, I believe. Are you buying in this crypto winter?

MOHAMED EL-ERIAN: Not yet. You know, I must say, I was more interested this weekend, when we saw 17 and 18. Look, crypto is going through what most innovations go through, which is, round one, you get overproduction and overconsumption. And the reason why you do that is because you suddenly lower the barriers to entry to a certain activity, and you get too much consumption of it and too much production of it. And we saw that with what's proliferated on the supply side.

And we saw lots of people coming in who didn't quite understand what the crypto space really is. They just saw prices going up and thought they would go up forever. So we had a massive speculative demand. We're washing all that out. You're washing out the supply side and the demand side. And the hope is that you reestablish a stronger foundation, as tend to happen with innovations.

That happened during the steam engine. It happened during fiber optics. It happened even during securitization into 2000. The first round isn't particularly good. A lot of people get hurt. The second round, it comes back more solid. So I think that's what crypto is going through. Because I don't fully understand the dynamics of how far are we in this adjustment, I haven't bought yet. But there certainly will-- I will be following it very closely.

- OK, you said you were interested in the weekend, or at least more interested relatively, when we saw, I believe, Bitcoin at around 17,000. We also saw Ethereum dip below 1,000. What would the fair value, from your perception, be for some of these major cryptocurrencies, once we do see kind of that full washout take its course?

MOHAMED EL-ERIAN: And that's the question I don't think anybody can answer, Brad. It's a really, really tough question. You know, the reason why I came in at 3,000, the reason why I got out at 19,000, which was way too early-- I saw it then go over 60-- is basically looking at the technicals, looking at the charts, and trying to figure out has it overshot. I got the overshot correctly on one side, on the way down. I didn't get it correctly on the way up.

So rather than trying to figure out what the fair value is, which is very hard to do, and I certainly cannot do it, it's a feel for when a certain price has overshot, and when you think it's now going to correct over time. It's not very scientific, Brad, I must admit. It's more gut than anything else.

- Mohamed, just lastly while we have you, we know you're a huge Jets fan. Are they going to do any better this season?

MOHAMED EL-ERIAN: Oh, Brad, that's an even harder question. I'll tell you what. Let me tell you what I will do and what many, many, many people will do. We'll go into the season thinking they can do better, and then we're going to be disappointed. We're going to be washed out, if you like, by their performance. That's what I think is the best prediction I can come up with about the Jets.

- We've seen the stands get washed out, similar to some of the crypto holders, if you will. Thanks so much for joining us here this morning, Mohamed. Queens College Cambridge University President Mohamed El-Erian joining us this morning. Thanks so much.