Top economist Mohamed El-Erian says markets, Fed need to toughen up

Economist Mohamed A. El-Erian in an exclusive interview on Thursday said that the Federal Reserve was slow to act and may have to maintain its hawkish stance even if financial conditions in the U.S. worsen.

His comments were made during a Twitter Spaces interview hosted by Pensions & Investments Editor-in-Chief Jennifer Ablan.

Mr. El-Erian is president of Queens' College, Cambridge, and chief economic adviser at Allianz, the corporate parent of Pacific Investment Management Co. LLC where he formerly was CEO and co-chief investment officer.

"I was worried last year that the Federal Reserve didn't fully appreciate the inflation dynamics and had fallen in love with the 'transitory' concept," he said. "They were falling behind."

If Mr. El-Erian were at the Fed now, he said he would do three things — maintain the hawkish talk that has been at the forefront of recent public comments from Fed Chairman Jerome H. Powell, work on evolving guidance away from lagging indicators and start to look at creating a new monetary framework.

"The monetary framework that's in place right now that was put in place in 2021 and assumes a world of deficient aggregate demand, whereby we are dealing with a world of deficient aggregate supply," he said. He added that it's important for the Fed to start monitoring non-banks for potential stability risks in order to avoid getting caught like the Bank of England was earlier this week.

The market might also need to adjust its mindset. The current monetary framework isn't the only thing over-optimized to the past, he said. Markets may expect the Fed to pivot or find some other way to step in if financial conditions worsen in the U.S. But with inflation remaining persistently high, he said, backtracking now could make things worse.

"We had a wonderful liquidity paradigm for 10 plus years — almost 14 years. Markets have to adjust to a less comfortable liquidity paradigm. We mustn't look to the Fed to be our BFF — best friend forever — all the time."

In addition to tighter liquidity conditions, markets may need to think about risk in new ways. Mr. El-Erian said banks have largely been derisked but that doesn't mean that risk is gone from the financial system writ large.

"People often look in the wrong place for systemic risk," he said. "Systemic risk lies in the non-banks."

If market moves push non-banks into becoming forced sellers, he added, that could result in changing market conditions, such as tighter margin calls or adverse pricing. If that happens, the risk profile of non-banks could shift significantly. It may also become more difficult to handicap broad market moves. Mr. El-Erian said that he's been "mostly in cash for awhile now" and doesn't anticipate going on the hunt for bargains.

"I would like to see significant stabilization in markets," he explained. "Markets overshoot on the way up and overshoot on the way down. ... We are at attractive levels for individual names — not the market as a whole. We have to overcome these macro transitions, these uncertainties. ... I'd rather miss a few percentage points on the upside and get some certainty or less uncertainty about the market stabilizing, then go in here in a market that's still fragile in terms of technicals."