If economic conditions are fine at home but issues are brewing abroad, what narrative should the Federal Reserve pay more mind to as it steers monetary policy?
That’s the question posed by Allianz chief economic adviser and former PIMCO CEO Mohamed El-Erian on Yahoo Finance’s Influencers with Andy Serwer.
El-Erian said the Fed faces an “inherent contradiction” between domestic economic conditions, where he sees a case for tightening policy, and geopolitical concerns abroad, where Europe and China are slowing.
“So you have one green light here, and one either flashing yellow or flashing red here,” El-Erian said. “So what [the Fed has] done is they swung too much in favor of one and now they’ve swung back too much in favor of the other.”
El-Erian was referring to the Fed’s switch in tone between the December and the January Federal Open Market Committee meetings, where Chairman Jerome Powell upended the central bank’s previous commitment to gradual rate hikes in favor of being “patient” due to risks overseas and “muted” inflationary pressures.
In the meantime, the Fed has committed itself to “data dependency” as it moves forward on monetary policy, which El-Erian supports. But he warned policymakers against being too persuaded by short-term market movements and economic indicators.
“At the end of the day, you risk become co-opted by the markets. No one wants central banks to be co-opted by markets,” El-Erian said. “And two, you risk being a source of instability.”
Reversing unconventional monetary policy
El-Erian said central banks around the world are already introducing uncertainty into markets. The European Central Bank has extended its long-term lending facility to prop up a sluggish eurozone and the Bank of Japan is still using negative short-term interest rates to tackle weak inflation.
These unprecedented monetary policy tools will at some point have to transition back to more conventional policy, El-Erian said.
“It’s clear to me that one systemically important central bank can handle it, but can three systemically important central banks do it? I don’t know.”
El-Erian also said he worries about elevated asset prices as a result of “years of central bank support.” He said plummeting asset values at the end of last year in reaction to the Fed being “too hawkish” showed just how sensitive markets are to central bank actions.
He elaborated that the Fed would prefer not to have that much influence on the market.
“If you talk to central bankers and they were completely honest, they would say, ‘you know what? We understand that we influence markets. We don’t like the extent to which markets have held us hostage, we just don’t know how to get out of this.’”
Still, El-Erian said central bankers remain “best friends forever” with the market, adding that markets are closely intertwined with the real economy.
Brian Cheung is a reporter covering the banking industry and the intersection of finance and policy for Yahoo Finance. You can follow him on Twitter @bcheungz.