A recession ‘is absolutely the risk’ if the Fed acts too late on inflation: Mohamed El-Erian
Mohamed El-Erian, president of Queens College, Cambridge, joined Yahoo Finance Live to discuss the risks facing the U.S. economy, the Fed, inflation, and the labor market.
JULIE HYMAN: But also, importantly this hour, we are going to be watching for President Joe Biden. He is expected to speak about the risks to American democracy. That, of course, one year after thousands of protesters attacked the Capitol in an effort to overturn legitimate election results. You see there the podium where he will be speaking in just a bit. We will be taking those remarks live and reflecting in other ways on this somber anniversary today.
But in the meantime, we have to talk about the reflections that the market has been making over the past 24 hours, given the release of those Fed minutes yesterday. I want to bring in Mohamed El-Erian. He's president of Queens College Cambridge and, of course, an advisor to Allianz as well. Mohamed, thank you so much for being here this morning.
I want to talk about this recalibration that we seem to be seeing in the wake of the minutes yesterday. What do you think is the biggest change in perception here? Does it have to do with the possibility that not only are we going to see the wind down of the bond buying program but perhaps even starting to shrink the balance sheet, or what do you think was the biggest pivot there?
MOHAMED EL-ERIAN: Good morning, Julie. That is the case. I think the market is now having to cope with the notion that not only is QE ending, not only are rates likely to be hiked three times this year, but in addition, the Fed may start to reduce its balance sheet much earlier.
And the big contrast is between what the minutes said and what people heard at the press conference back in December at the end of the FOMC meeting. And that's why you got such a big adjustment in markets.
BRIAN SOZZI: Mohamed is the everything rally in stocks over?
MOHAMED EL-ERIAN: It's hard to say, Brian, because the everything rally was led by two things, one of which is going out, the other we don't know. One is massive and predictable central bank liquidity injection. That is ending.
But there was another issue that drove this everything rally, which is behavioral, the fact that people were conditioned to buy on dips, the fact that equities dominate in relative space, may not dominate in absolute space, but they dominate in relative space. So the big question, Brian, is the behavioral one.
Will markets start thinking in absolute terms and not in relative terms? If they continue thinking in relative terms, equities still dominate everything else out there.
JULIE HYMAN: Mohamed, you have been cautioning for quite some time that the biggest risk to markets was the Fed making a blunder of some kind, not exiting quantitative easing in a smooth fashion, if you will. And you've been saying this, like I say, for quite a while, at least a year we've been talking to you about this.
So where are we now? What is the biggest risk when you look in particular at the Fed's exit and what it could look like and what could go wrong?
MOHAMED EL-ERIAN: So the market sensed it yesterday, Julie. The biggest risk is that the Fed, after miscalculating the inflation dynamic, sticking to its transitory characterisation for too long, falls way behind the curve and then has to tighten significantly in a small span of time. That is the biggest risk.
The notion is, you've been pressing the accelerator. Now, not only do you have to ease off the accelerator, but you have to hit the brakes. And that is consequential for earnings. It is consequential for liquidity. That's the biggest risk. And that's what the market sensed yesterday.
My hope is that the Fed will be able to get it right. But we have to acknowledge the probability of it doing so, given that it's so late, is small. That's why I've been advocating for quite a while for them to start early so that we don't get an abrupt change in monetary conditions.
BRIAN SOZZI: And Mohamed, just staying on that, if we do get that abrupt change in monetary conditions, do you think the Fed ultimately tips the US economy into recession early next year?
MOHAMED EL-ERIAN: That is the risk. We haven't had a situation in the past in which the Fed has been really late and the Fed hasn't ended up tipping the economy into recession. That's why we want to avoid that outcome. That is absolutely the risk, Brian.
Look, Brian, it's easy in terms of analyzing the issue. The question is, what is the right thing for the Fed to do? Inflation is going to stay for a while, but it will come down at the end of the year. But it may come down for the wrong reasons. We don't want inflation to come down because the Fed has to slam on the brakes. We want inflation to come down in an orderly fashion.
There's a small window for this, but that window is closing. And the Fed has to move more quickly early on.
JULIE HYMAN: Phew. So Mohamed, this obviously is painting a tricky picture, both for the economy and for markets here. Jay Powell and company, they seem acutely aware of these risks, even if they are late to move on them.
And I think that there are folks who, like you, are starting to raise this specter of this happening too quickly.
We're seeing now Kamala Harris, the vice president, begin to speak. We'll listen in once the president speaks.
We are starting to see people like you raise the specter of recession. Is there a risk that the Fed hears those calls and then backs off of its tightening?
MOHAMED EL-ERIAN: It's certainly a possibility. The trouble is inflation. In the old days, the Fed could do U-turns, and it did. If you remember, it did a massive U-turn in January 2018. It did a massive U-turn after the taper tantrum. The Fed can do U-turns as long as inflation isn't a problem.
Now inflation is an issue. And the employment side, as they acknowledge themselves, they are near maximum employment. If labor force participation doesn't go up, the Fed will find it very difficult to do a U-turn. So yes it is possible that the Fed does a U-turn. But inflation has to behave much better than it has so far for that.
BRIAN SOZZI: Well then Mohamed, do you think these looming hikes from the Fed, do they even bring down inflation? Because we're getting some early earnings reports out this morning from food makers like a Conagra. They have raised their inflation expectations. Definitely, it's quite surprising. But the Fed, can they help bring that down?
MOHAMED EL-ERIAN: They can now, but they should have started earlier, Brian. You're absolutely right. Transitory is not a time concept. Transitory is a behavioral concept. People think it is temporary and will be reversed and therefore don't change their behaviors.
But as you pointed out, we're getting evidence of behavioral change in price setting among companies. We're getting evidence of behavioral change in wage bargaining. Look at what happened to the quit rate. And we also getting evidence of behavioral change on the consumption side. So yes, the Fed has got a bigger problem.
The way I view it, Brian, is very simple. The Fed delivered a wonderful year for markets in 2021 at the cost of a much more complicated outlook in 2022. And that complicated outlook is for policy. It's for the economy. And therefore, it's a more uncertain outlook for markets.
JULIE HYMAN: I want to bring up fiscal policy as well, Mohamed, and bring up, again, this day that we are marking today, January 6, a year after those protesters attacked the capital. Markets didn't move much that day. They didn't move much the day after, even as it became increasingly clear, perhaps, how serious that attack was.
Why do you think markets are not more concerned about this? Is there, I guess, a confidence in American democracy and stability of government here? And if that's the case, are you at all concerned, or are there things you're going to be watching to see to make sure that that stays the case?
MOHAMED EL-ERIAN: So I think markets didn't react in the way you would expect them to react because they felt they were shielded from virtually everything by liquidity. I can point to many other instances in which we would have expected markets to react. But, rightly, they didn't because liquidity is all that mattered. As long as the Fed was buying so regularly, you could bet on the markets being supported.
And the broader question, Julie, is a really important one. I do, I believe democracy is here to stay. I think the US is the strongest democracy in the world. I don't worry about all these things. But I do worry about the fact that the political environment is going to complicate movement on something we need, which is the soft infrastructure effort, which is government efforts to increase labor force participation, to increase productivity.
We had the hard infrastructure. We now need the soft infrastructure. And if we don't get that, then productivity and growth potential is going to be less than it should be in this country.
JULIE HYMAN: And Mohamed, do you think that some of the measures in that Build Back Better package include some of what you're talking about? Or are you talking about a different bill entirely?
MOHAMED EL-ERIAN: No, I'm talking about that bill. There's lots of things, from childcare to the labor retraining and retooling that can address labor force participation and productivity. And it's really important to move on. I mean, we now know the supply side is the issue. That's the big paradigm change.
Before 2020, it was all about the demand side, efficient aggregate demand. Now it is about the supply side and supply responsiveness. And there's a lot that can be done to improve the supply responsiveness.
BRIAN SOZZI: And Mohamed, amidst all this, we have a jobs report tomorrow. It's somewhat getting lost in the sauce. What impact do you think the omicron variant is having on the economy right now?
MOHAMED EL-ERIAN: So I think the omicron is making the supply side more difficult. And the key numbers to look at, although it's early days, relative to omicron because of what the jobs report captures, but it's labor force participation. We need to see labor force participation go up. That is probably the most important metric tomorrow, followed by wages, followed by job creation.
So the hope is that labor force participation continues add jobs as it did last month. But I worry that omicron is not going to impact demand as much as it's going to impact supply. And that's particularly true for the zero COVID regimes, like in China, for example. We will see further supply disruptions, supply chain disruptions coming out of China because of the way they are approaching COVID.
JULIE HYMAN: And so then, to put all of this together, between omicron, between those more structural issues that you were talking about with the so-called soft infrastructure, it sounds like you think we cannot have really full employment, whatever full employment even means at this point, without those kinds of measures.
I mean, and I guess I should ask you, what does full employment mean at this point? What would it unlock if we had child care measures and some of those other things that you talked about?
MOHAMED EL-ERIAN: It would unlock a recovery in labor force participation to the levels that we have seen a few years ago. It is possible, Julie. This is not something that is beyond policy. We just need a political agreement.
This is still a very robust economy. If we avoid a policy mistake-- big if-- but if we avoid a policy mistake, this economy has all the ingredients to continue growing and grow in a more inclusive manner. But we do need help on labor force participation and productivity. We do need help on the supply side because you're countering the impact of the pandemic. And that's not going to go away any time soon.
So we do need those policies. And if we get that, they will turbocharge an economy that's able to do really well and able to be more inclusive.
JULIE HYMAN: Very interesting perspective here this morning. Mohamed, it's always great to see you. Happy 2022. Mohamed El-Erian is president of Queens College in Cambridge and an advisor to Allianz. Thank you again.