Mohamed El-Erian: inflation, disinflation and the mistakes of central bankers

Merryn talks to economist Mohamed El-Erian about the state of the global economy, how the Fed became hostage to the marketplace, and how you should position your investments in distorted markets.

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Merryn Somerset Webb: Hello, and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. It is 25th April 2020, and I have yet another treat for you today. We’ve been on a good run for the last couple of weeks, and here is going to be another good one.

I have with me today Mohamed El-Erian, the president of Queen’s College, Cambridge, and we are going to talk about pretty much everything to do with the global economy and then onto investment. Mohamed, thank you so much for joining us today. Welcome.

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Mohamed El-Erian: Thank you, and thank you for having me.

Merryn: Oh, a pleasure. Now, I think we’d better start with a bit of misery. I’m hoping we might end outside misery, but we’re going to have to start there. Now, let’s talk about the global economy. So, we had the new forecasts out from the IMF a few days ago. They were revised forecasts for pretty much all of the Member States, well, 85/86% of 190 Member States or so. They downgraded global growth by a percentage point or so from 4.4% down to 3.6%, and they also downgraded very slightly next year’s forecast.

So, we’re not going to gain back any of our lost growth this year. Next year, it’s all looking pretty miserable. So, let’s talk about that a little bit. What do you think are the main drivers behind that, and how bad is it going to get? How bad is it going to feel, should I say?

Mohamed: So, as you say, these are pretty stunning and sobering revisions. It’s not often that three months into the year, the IMF revises projections that it made just in January. And the extent of the revisions is what is particularly striking. As you pointed out, 86% of the member countries are seeing lower growth, and not just by a little, by a lot. And it’s not compensated next year. So, this is a major change in the growth outlook. Why? A few reasons.

One is that even before the Ukraine War, we had slowing going on in the three major economic areas, Europe, the US and China. Each had their own reasons for slowing, but they were giving quite a huge impulse, a stagflationary impulse, to the global economy, lower growth, high inflation. Then comes the Ukraine War. That entails major disruptions to supplies of a number of very important commodities. So, you have both a supply shock and inflation shock. It undermines confidence, particularly in Europe, so you have demand issues as well.

And put all that together, you get these divisions. What’s worrisome to me is, it’s not the end of the revisions.

It would not surprise me if the next round sees a sharp revision in Europe’s growth rate in particular for this year.

Merryn: OK, and again, based on the War and the rising energy prices, etc, from that?

Mohamed: Correct, and if ever we were to have sanctions on gas exports from Russia to Europe, then the revisions would go into negative, into a recession for Europe.

Merryn: OK. Let’s go back a little bit to before the War in Ukraine. You were saying that there was already a slowing impulse then, based, presumably, on the monetary authorities beginning to row back from money printing, beginning to row back from the huge levels of stimulus during Covid, and that was already giving us some kind of slowing impulse throughout the global economy. Or is there something else in it?

Mohamed: Well, there were several factors. So, if we start in China, it was trying to continue with the zero-Covid policy in the face of Omicron, a much more infectious variant of Covid. It is almost impossible to run a zero-Covid policy without disrupting the real economy when you have Omicron around. And already, China was slowing and was causing a renewed round of supply side disruptions, which were impacting Europe and the US.

So, in China, it wasn’t about monetary policy. It was about the Covid policy that was pursued. Unlike the West that is trying to live with Covid, China is trying to still eradicate, completely, Covid. That’s a significant difference in strategy.

Merryn: Mm-hmm, but it’s impossible for that not to have an impact globally, and impossible for that not to have an impact on inflation is that supply chain disruption is going to continue. And it looks like it’s going to continue, possibly… It’s hard to see how it ends, now with Shanghai being locked down on and off all the time and Beijing beginning to be concerned about rolling lockdowns there. It’s hard to see how the global supply chain ever goes back to normal.

Mohamed: That’s correct, and that was actually clear almost a year ago. I remember the time a few of us were warning against this notion that the cost-push inflation would be transitory. If you talk to the companies involved, most of them did not feel this would be transitory. They felt that it would be prolonged, it would last for most of the year and into 2022. Now, the renewed China disruptions mean that we will have supply disruptions for most of this year as well. So, yes, absolutely, the supply side is not going to heal as quickly as we’d all like it to heal.

Merryn: Yes, I looked, and I saw a number this morning that made me think, people talk at the moment about inflation peaking and how we’re near peak inflation, it’s going to turn around, the Fed will be saved, etc. But the price of farm inputs in the UK has gone up 23% in the last six months alone. Now, a lot of that is fuel, but also in there you’ve got feed and fertiliser, etc. With those kinds of numbers, it’s impossible to look at that and go, yes, OK, inflation’s probably peaked.

Mohamed: That’s absolutely right, and the same with wages. Now, it’s important to distinguish which inflation are we talking about. In the US, headline inflation at 8.5%. Has that peaked? Maybe. It could well have peaked, but if we get another disruption, that would be reversed quite quickly. But if you look at the core measures, which are influenced less by energy in particular, that has not peaked. So, we should expect inflationary pressures to persist.

Now, there’s a camp, it used to be the transitory camp, now it’s called the immaculate disinflation camp, that believes that somehow, inflation’s going to come down very rapidly, not just because of base effects, which will be in play, but because we will see all these inflationary pressures just disappear. It is highly unlikely, and keep an eye on the labour market because so far, wages have been lagging inflation in a serious way, but there are signs that wage growth is picking up, especially as people change jobs, which they’re doing much more frequently now.

Merryn: And what are these signs? When you say there are signs, you mean just that you can see in the data that when people move jobs, I’ve seen this data, they’re getting fairly impressive uplifts, 10/20/30/40%, on shifting jobs. But you’re not necessarily seeing the rises come through for people who remain in steady the employment with the same employer?

Mohamed: Correct. So, the first round is those who change jobs. And there’s been a recent survey done of over 2,000 US residents who changed jobs, and about 30% of them gained 6 to 10% increases in their wages.

Another 25% saw 11 to 25% gains. Over 10% saw 26 to 50% gains, and it goes on. So, round one is job hopping, if you like, but if you’re an employer and you’re hiring people at a higher entry wage, it’s only a matter of time when you have to adjust everybody else’s wages.

Merryn: Yes, it’s interesting, isn’t it? When we’ve been looking, at MoneyWeek, at what happened in the 70s, etc, and everyone just slightly behaves, when they look back at the 70s, as though it was unionisation that drove wage increases. The unions were the first point, but actually, of course, the unions still existed in the 1960s, and you didn’t see this huge wage inflation then. So, it is entirely possible that it’s inflation that drives unionisation, which drives wage rises, rather than the other way around. So, we may just be at the beginning of this cycle.

Mohamed: We could. The one big difference with the 70s, and I think it’s why we’re not going to see the sort of spiral we saw then, we’ll see one, but much smaller in magnitude than what we saw then, is you don’t have indexation. That was a turbocharger in the 70s. We don’t have that today, but we will see a cascading of wage increases throughout the labour force.

Merryn: OK, because we have an unpleasant dynamic now where real wages are falling, and of course, that’s an obvious recession sign. But there’s a chance that real wages will at least catch up.

Mohamed: Oh, absolutely. Remember, there are three distinct phases in the wage adjustment process. One is, they fall behind because inflation surprises them. It is unanticipated. Second, they look to compensate for past inflation, and then, third, in addition to compensating for past inflation, they look to compensate for future inflation. You get anticipatory demands. That happens when inflation remains high and when inflationary expectations are the anchor.

So, that’s why it’s really important that central banks try to catch up with developments on the ground. The Fed in particular is very late.

Merryn: Well, this is the problem, isn’t it. They spent a very long time last year saying this is transitory, this is transitory. It’s going to go away, therefore we don’t have to do anything about it. And obviously, the markets have been way ahead of the Fed, and now are at the point where the Fed has, A, lost credibility and, B, has got so much catching up to do, that if they try and do that catching up, they will definitely cause a hard landing.

Mohamed: That’s absolutely right. I’ll give you two things that really caught my attention. It’s not that it took until the end of November for Chairman Powell to, quote, retire, unquote, transitory from his vocabulary. He should have done that way earlier, and he should have started adjusting policies before, but the week in March, the week, in which we printed a 7.9% inflation print, the Fed was still injecting liquidity into this economy.

QE hadn’t ended yet, which gives you a sense of how disjointed monetary policy has been from inflation.

Merryn: That’s a stunning kind of complacency, isn’t it?

Mohamed: Yes, I think they got caught hostage by a monetary framework, just a so-called new monetary framework that was designed for a world of deficient aggregate demand. And they didn’t quite realise that we had deficient aggregate supply. So, they got caught. They shouldn’t have, but they did, and catching up is hard, and now you’re seeing a bit of the typical developing country dynamic, which is worrisome for the world’s most powerful central bank, which is, every time they speak more hawkish and try to catch up with the market, the market runs away from them.

And the day last week, in which Jerome Powell sounded more hawkish than people expected is the day breakeven inflation went higher, not lower, and reaching a new record level. And you talk about ten-year breakeven inflation, so that’s the implied market probability of inflation over a ten-year period.

Merryn: OK, so they’re definitely in the can’t-win zone. Now, there is an idea that there’s a woke element to this kind of inflation, in that one of the reasons that the Fed left it so long to start acting or to really accept is that they wanted to be sure that they had full employment in advance of raising rates or tightening up monetary policy. It’s all, the idea being, they wanted to make things more equal, fairer. But of course, there is nothing that intensifies unpleasant inequality more than very sharp inflation, particularly, as you say, very sharp core inflation.

So, again, they’ve got this the wrong way around.

Mohamed: Yes, and I think there’s something else, if I may, which is that they were held hostage by markets. The Fed has been worried that if it moves to tighten policy, if it moves to tighten what are historically, still very loose financial conditions, it will cause unsettling volatility in the marketplace, because that’s what has happened in the past. We have the example of, not just the taper tantrum of 2013, but we have the example of the fourth quarter of 2018, when the Fed was tightening policy for good reason. That’s what the economy needed.

The markets did not like it, and in January, the Fed had to undertake a very embarrassing U-turn, even though the real economy was doing fine. So, I think there’s also the influence of markets and the fact that the Fed fell into these very unhealthy interdependencies with financial markets.

Merryn: OK, so what is the best thing for them to do from here? To just accept the hard landing, to accept higher long-term inflation, maybe change the target? If you were the Fed, it’s too late to say what would you have done, but starting from here, what’s the best thing to do?

Mohamed: So, I would hate to be the Fed at this stage.

Merryn: Oh God, me too.

Mohamed: Yes, absolutely hate it. And this is important because this is a problem of their own making. They could have very easily started ending QE in the middle of last year. Everything was fine, and they should have, and many people, well, some people, were urging them to do so. And even when they declared inflation not to be transitory they should have started then aggressively, but they didn’t. They were very, very slow.

Look, I don't think there is an easy pathway to an orderly disinflation. The first best policy responses, I don't think are still available. It was. It is no longer available. So, what would I do if I were the Fed? First I would be honest. I would explain why I got my inflation call so wrong. They haven’t yet. I would explain how I have modified my models and my thinking to make sure that I don’t repeat the mistake, which they’re still repeating.

I would alter the new monetary framework, which is problematic in this environment. So, I would first do all this in order to regain some inflation credibility. Then comes the really difficult issues. I would ask myself the following. It is likely that I’m going to make a mistake because I am really late. I don’t want to make a mistake, but it’s likely that I will make a mistake. If I end up making that mistake, which mistake can I live with, that of creating a recession, or that of having high inflation persist into next year?

And I would be very clear about how I measure the likelihood and the implications of those mistakes, and I would then make a courageous choice, I would say, and then go out and communicate, saying, we are aiming for an orderly disinflation.

We will need a combination of luck, skill and time. To the extent that time is no longer available, I would say I would rather err on a little bit more inflation for longer than pushing this economy to recession. That’s what I would do, but I want to stress, it’s not a first best, and unfortunately, I don't think that first best is available.

Merryn: Is there not a horrible possibility that we might be both a hard landing and inflation, a longer-term stagflationary environment that would come with, as we just discussed, this changing globalisation shift of China, involuntarily, out of the supply chain, which, by the way, we wrote about even before Covid, and you were probably talking about before Covid as well, that barriers around the world were already coming up.

The great age of advancing globalisation, it was already coming to an end even before Covid and even before the War in Ukraine. So, we have that. We have this business where we can’t really do much with monetary policy to help anything out. And of course, we have what, you’ve written about this as well, I’m not sure what you call, or other people call, temporal dislocation, the pulling forward of growth so that we haven’t got much left for the future. So, we may end up with both inflation and recession.

Mohamed: So, you ask me what would I do. If you asked me what is likely to happen, I would say you’re absolutely right.

Merryn: Oh, well, that’s depressing.

Mohamed: And it’s not only because of the factors that you’ve cited that are absolutely correct, the changing nature of globalisation being one, the fact that we’ve borrowed growth from the future to a large extent, the fact that we have conditioned market for too long to depend on ample and predictable liquidity injections, and all this is changing. But in addition to all that, I suspect the Fed will do the following. Having failed to ease its foot off the accelerator, it will slam on the breaks. It wouldn’t surprise me if we see two to three 50-basis point increases by the Fed.

And then there will be concern that the economy is slowing too much, so they will take their foot off the brakes a little bit, and then later on, they’re going to have to put their foot back on the brakes, and the stop-go monetary policy is the one that will accentuate the stagflationary forces that you’ve talked about. So, if you ask me what is likely to happen, as opposed to what should happen, what is likely to happen is that we go into next year with both a growth and an inflation issue.

Merryn: OK, so stop-start, stop-start, stop-start. You know, if you drive your car like that, you end up with clutch burnout, which is something I found out last week. And probably the lack of parts available around the world, burning out your clutch and needing a replacement is really expensive.

Mohamed: And how do the people in the car feel?

Merryn: People in the car feel cross, but maybe the driver feels really cross about the roadworks in Edinburgh and sometimes is a little bit too stop-starty on the clutch.

This stuff happens. So, I have sympathy for the Fed. I also wonder, when I look at central banks around the world, if perhaps we always thought that, perhaps, independent central banks could do more than they could, in that we gave them credit for the very long period of low inflation and disinflation, when, in fact, that may just have been a global dynamic with the disinflationary impulses coming out of China, the opening up of the world to become a global labour market, etc.

That low inflation was going to happen anyway. Absolutely nothing to do with the central banks, and this new age of higher inflation will have absolutely nothing to do with the central banks, and they’ll end up with no choice but to raise their inflation targets to 4 or 5% and be done with it for a decade.

Mohamed: So, you’re even harsher than I am. No, I do think there were secular disinflationary forces in play. You mentioned the globalisation. First, we brought in Eastern and Central Europe into the global labour force, then we brought China into the global labour force, and that was disinflationary.

Then we had what I call the Amazon, Google and Uber effects, which is technology allowing us to be better in price discovery, allowing us to use existing stock of assets like cars to deal with excess demand. So, we had these massive disinflationary forces, and then central banks, on top, did earn inflation credibility.

I think the problem was that they got co-opted by markets, and it started in 2010, when a decision was taken by the Fed, August 2010, to use unconventional policies, not just to fix dysfunctional markets, not just to address market malfunction, but also to pursue macroeconomic goals. At the time, if you recall, the summer of 2010, Congress was horribly divided, we had the Tea Party that had emerged, governments were going to be shut down.

And the Fed made the decision that there needed to be a bridge to a better world when fiscal policy and structural reforms could be implemented. What they didn’t realise at the time was that bridge would be very, very long, a decade’s worth of a bridge. And in the process, they would condition markets to be like little kids expecting sweets all the time. And they became hostage to the marketplace, and that has caused monetary policy to be run much more expansionary than before.

Remember, we continued running emergency measures when the economy was fine, and the only reason we did that is because central bankers were worried about the impact on the markets if they were to go back to conventional monetary policy.

Merryn: Mm-hmm, talk about reaping what you sow. Right, let’s talk about how we can possibly invest into this kind of misery. We know that MoneyWeek readers are very much equity and equity market investors, and I think we all know that valuations are still high, by historical standards, in pretty much every market. Maybe the UK and maybe Japan, etc, there are a few markets that are knocking around fair value, but in general, everything’s still quite expensive. Where do we go?

Mohamed: It’s a very difficult investment environment because the safe asset has been completely distorted, so you get the following conversation. And I’ve been on investment committees where the conversation goes as follows. We start with the view that equities are overvalued, and therefore, we should reduce our exposure. Then the question is, where do we go? So, let me tell you what a recent not-for-profit US investment committee did.

US, we should go into cash. Oh no, we can’t go into cash. Inflation is now 8.5%. that’s a guaranteed negative real return. You’re right. We should go into bonds. No, we can’t possibly go into bonds. Bonds are adjusting. Not only are yields still too low, but in addition, there’s a capital loss as yields go up, so we can’t do that. How about commodities? Oh, they’re really volatile. How about crypto? Oh, there’s a reputational issue there.

And that committee, which started by seeking to lower equity exposure ended up increasing equity exposure because equities are viewed as the cleanest dirty shirt. They are not clean, but they’re cleaner than many other assets. So, if you solve that problem in relative space, you will end up by not just keeping high equity exposure, but by viewing equity as perhaps your best defence against inflation.

Merryn: Interesting, and did that group stay in mainly US equities, or did they spread more globally?

Mohamed: So, in that case, they stayed in US equities. Now, the problem with that… And we are seeing this play out, and I’ve been urging since five months, to just take some chips off the table. The problem with that is that the moves in equities can be much sharper than the loss in the value of your cash over time. And that is what we have seen. So, depending on how heavily invested you are, and it varies from investor to investor, and depending on whether you’re confident, you can avoid the behavioural traps.

You know better than anybody else that we tend to fall into all sorts of behavioural traps that make us do the wrong thing at the wrong time. Selling at the bottom of the market. That happens a lot. So, people have to ask the same question that central banks have to ask, which is, can I live through a very unpleasant period, because things are really distorted right now? And if you cannot, then ask the question, what is your recoverable mistake, and what is your unrecoverable mistake? And let that enter into your calculation as to how you should change your asset allocation.

Merryn: So, again, the best we can do is ask ourselves the question, which mistake would I rather make?

Mohamed: Yes, and as bad as that sounds, that’s what happens when the safe asset has been distorted so much by central banks, that in the old days, it would have been, let’s go into cash. We may not have the upside of equities, but at least I’m protecting against the downside. And I still have my equity exposure that gives me an upside.

I just have less of an upside. And that was the good old days when cash wasn’t being eaten away by inflation and when bonds weren’t heavily distorted by years of asset purchase buybacks. So, in the old days, you had correlations that would allow you to take some chips off the table and retain a claim on the upside. Not as big, but still reclaim a claim on the upside. Now people are paralysed because the safe asset is distorted and cash is subject to being eaten by inflation.

Having said that, that’s the world we live in, and still, it does make sense. If you’re 100% equities at this point, there is an argument for taking some chips off the table.

Merryn: And the bond market, some value is gradually emerging there, particularly in corporate bonds, yes?

Mohamed: It is. When I want to sound positive, which I try to…

Merryn: We would like that. Give it a go.

Mohamed: I call it a restoration of value. So, we are seeing a restoration of value in both bonds and equities that will serve us well in the future. Now, we haven’t finished the process of restoring value. It’s still going to take some time. But the good news is that, as bond markets become less distorted, as equity prices start to reflect fundamentals and not just liquidity, that’s a good thing for future investments.

Merryn: OK, well, that’s a very positive thing to say. What about gold? Can we protect ourselves with gold? Obviously, we did in the 1970s, but that was connected to the end of gold standards and all sorts of other things going on at the time. Can we protect ourselves with gold today, do you think?

Mohamed: We can, to some extent. Recently, gold has played a better role in protecting us as people got rightly concerned about inflation. But the role of gold itself is now being challenged by crypto, and therefore you no longer have the dominance of gold that it used to have. It now shares this with crypto because a lot of people believe that crypto is a better way to defend yourself against inflation than gold is.

Merryn: But that’s interesting, and I’m really interested that you say that, because from what I can see, what has happened over the last three or four months is that crypto has proved itself to be exactly not that, in that it’s moved almost in lockstep with risk assets, as opposed to in any kind of way that suggests it offers diversification from risk assets.

Mohamed: That is correct, and that is because there’s a common global factor. And that common global factor is the change, the ongoing change, in the liquidity paradigm. I’ll give you a very simple example, if I may. When I was at Pimco and someone was presenting an investment case, we would, of course, look at the fundamentals, we would look at the balance sheet, we would look at management, we would look at the business prospects, etc. And even if we ticked every single one of these things, there was still one question that was always asked.

Who will buy after us? The subsequent buyer does two things for you. First, they validate your purchase and push the price higher. Two, they provide you liquidity in the event you have to change your mind. Now, imagine I come to you and I say the subsequent buyer is a central bank with a printing press in the basement, an infinite willingness to use it, and they are non-commercial. They don’t care about price. They are non-commercial buyers.

That will make you buy assets across the piece. You will go and buy everything. So, crypto was also heavily influenced by these massive injections of liquidity by a predictable and non-commercial buyer. They weren’t buying crypto, but they were buying part of the capital structure that cascaded throughout the remaining elements of the capital structure. That is going away, and that’s why crypto is showing to be as sensitive to that factor as equities have and bonds have.

Merryn: OK, so there will come a point when crypto is something you want to hold to diversify and protect yourself once this dynamic has worked itself through?

Mohamed: That’s correct.

Merryn: And is it in your portfolio?

Mohamed: It was, then I sold too early and saw the price go up.

Merryn: Of course. How could you not?

Mohamed: How can I not? And I’m waiting for a better entry point at this stage.

Merryn: OK, so when this dynamic that we’ve just discussed plays through, that will be a time when you think it will be time to get back into this market?

Mohamed: Correct, as a small allocation. I want to stress, this is not your 20/30% allocation. This is up to 5% allocation.

Merryn: Yes, OK, well, we always say, with gold, 5 to 10%. So, if crypto is the new gold, I’m not sure I agree with you, by the way, but we’ll wait and see on that one. I hold, like you, a little bit of a crypto, but we’ll wait and see.

Mohamed: So, I don't think it replaces gold. I think it plays along with gold. But it has reduced some of the people who’d normally buy gold.

Merryn: Mm-hmm. So, you didn’t see quite the amount of cash coming into the gold market as you’d normally expect when inflation became obviously high?

Mohamed: Correct.

Merryn: Yes. I think we will have to leave it there, but that was so interesting, absolutely fascinating. Got to say, you’re one of the first people we’ve had on in a long time who’s been quite positive about the long-term future of crypto, so it was very interesting to hear and distracts us slightly from the depressing stuff in the first 25 minutes.

Mohamed: Yes, I would be even more constructive on the technology underlying crypto. I think that blockchains and other associated innovations are going to spread a lot.

So, if you are interested in crypto, you should really decompose what crypto is. And for goodness’ sake, don’t buy crypto if you think that that’s going to be a global currency. That’s not going to happen. Crypto will exist in the ecosystem, in the payment system, but it’s not going to be a global currency. So, my support is bounded, OK. I’m not a buyer of, this is the next global reserve currency.

Merryn: OK, that is also good to know. Mohamed, thank you so much for joining us today. We have really enjoyed that, and I hope you will come on again one day.

Mohamed: Thank you very much for having me.