PIMCO’s El-Erian: QE3 won’t produce the outcomes we want
Bloomberg wrote the following paragraphs about a recent interview with Mohamed El-Erian. What i thought was interesting was his belief that the Fed is out of bullets. Monetarists and Keynesians believe the Fed can still be effective by managing expectations. So the Fed is on a mission to improve its communication of interest rate policy.
Like El-Erian, I am sceptical of this policy turn, but what else can the Fed do? They say they have lots of tools left. Do they? My own scepticism stems from the lack of a transmission mechanism. QE is just the fed swapping bonds for reserves and this has no direct channel to credit creation in a system dependent on credit demand instead of supply. The Fed’s new communication strategy is small beer in the absence of fiscal measures. Bernanke has said as much and it sounds like El Erian is saying the same.
As for QE3, in August I told you the easing has already begun. The Fed knows that the quantitative part of QE has been a bust and so they have moved in a different direction to provide unconventional monetary stimulus. I believe they will continue to do so and will resist expanding the Fed’s balance sheet.
Much more below.
PIMCO CEO and co-CIO Mohamed El-Erian spoke with Bloomberg Television’s Betty Liu, Dominic Chu and Michael McKee about Europe’s crisis, the U.S. economy and where to invest safely in this environment.
El-Erian said that the Fed "doesn’t have enough policy instruments to deal with the challenges facing the economy" and that QE3 will not work. On investing opportunities, he said that "In the short term, the U.S. dollar is the best place."
Video for viewing here: https://www.bloomberg.com/video/83907050/
El-Erian on the unpredictability in global markets leading to extreme events around the world:
"Normally, we’re used to thinking of a bell shaped distribution. There’s a dominant theme and very thin tails. Today we’re looking at something different. We’re looking at a distribution that is much flatter and the tails are much fatter. Think of Europe. Increasingly, most people agree that Europe can no longer kick the can down the road. One of two things is likely to happen. Either the euro fragments completely or you strengthen the euro zone but change its construct. That is what the fiscal compact we just heard is about. Increasingly, as you look around the world, we are moving towards a bimodal distribution that has significant implications for how you invest."
On where he sees the most market impact:
"First, it is not just risk. It is also opportunity. One exciting thing about this world is that when there are major transformations, there are both risks and opportunities. The biggest risk is interest-rate risk in sovereign space is becoming credit and default risk. The most extreme example is Greece. It used to be viewed as interest-rate risk–in the government bucket as stable. It has now become default risk. We may as well see haircuts in excess of 50%. The biggest risk is that people’s mindsets don’t evolve to understand that the underlying characteristics are changing."
On whether the Federal Reserve should move on QE3:
"The Fed does not have enough policy instruments to deal with the challenges facing the economy. They’re trying to use communication as an extra tool now. WE have used rates, we have had QE, now you see them using communication, trying to push investors to take on more risk. The problem is two-fold. One is there is disagreement on the FOMC. Secondly, it is not a very effective policy instrument. There are not just limited benefits, but there are also costs and risks. The Fed is in a difficult position. It is trying to be active, but it does not have effective instruments at this stage."
On whether the U.S. is stuck in a liquidity trap:
"That’s one of the views. Which is why not just jump start the whole thing and give a high inflation target and hope the system reflates. Critics talk about how difficult it is to produce the right outcome. You could overshoot and create a different problem. The fundamental issue is that the Fed cannot solve this alone. It is a bridge to somewhere. This has to include other agencies stepping up to the plate. So far, only the Fed has been doing its job. The others seem to be asleep at the wheel."
On whether QE3 is appropriate for the economy at this time:
"I do not think that on its own [QE3] can produce the outcomes we want. The outcomes would be higher job creation and contained inflation. That is the fundamental issue. The Fed is willing to do things, but it cannot guarantee unfortunately outcomes. For good outcomes, we need other agencies to also be doing their jobs."
On what needs to happen over the next few months to get over the mountain of debt facing European nations:
"We’re seeing an important shift in the narrative. It goes from saving the periphery to strengthening the core. We need to see Germany and France to agree on how they will ‘refound’ the euro zone. Secondly, we need to counter the continued fragility of the banks. We just heard about an Italian bank. Third, we need to be able to mix that containment with growth. Finally, we need to decide how the burden will be shared in the peripheral economies that are insolvent. It is quite a list. They will have to do a lot of work. Hopefully they will be able to do it."
On how Europe’s crisis will affect the U.S. and whether it will be a situation where nations around the world go up and down together:
"I think it will be a bit of the latter because it is a massive head wind. No matter how strong your internal dynamics are, there is this massive headwind called Europe. The banks are interlinked around the world. A lot of companies sell in Europe or export to Europe. We cannot avoid Europe. It is a significant headwind everybody has to cope with."
On the need for investors to stay defensive while remaining agile enough to take advantage of opportunities:
"One lesson from these big macro themes is that they tend to be indiscriminate. That is another way to say that they cause sell-offs in credit and stocks that are fundamentally sound. By focusing on the fundamentals and respecting the technicals, there are opportunities to be selectively offensive. Uncertainty and unpredictability should never lead to paralysis. It leads to figuring it out how the risk is changing and how the return is changing. We’re living in an exciting world where there are lots of realignments. Sources of risks and returns are changing."
On where to invest safely right now:
"In the short term, the U.S. dollar is the best place. It is the cleanest dirty shirt. There aren’t pure shirts anymore out there, so you have to focus on the cleanest dirty shirt. In addition to dollar exposure for the short term, stay focused on some emerging currencies that continue upward migration in terms of wealth and income. Stay away from the high-beta currency that are likely to be incredibly volatile in this less predictable world."
On whether U.S. stocks are also the ‘cleanest dirty shirt’:
"They are. But in this case, we have to ask the question. Alcoa is going to be very important as will other firms. To what extent are they being hit on revenue? To what extent can they continue to contain costs? We’re going to get lots of information."
Source: Bloomberg Television