Mohamed A. El-Erian
Mohamed A. El-Erian1
Homer Jones Memorial LectureFederal Reserve Bank of St. Louis
Good afternoon. It is a huge honor for me to be here today. At the outset, I would like to express my deep appreciation to Jim Bullard and colleagues at the Federal Reserve Bank of St. Louis. Thank you for inviting me to such a wonderful event. Thank you for the opportunity to visit this beautiful city and to reconnect with old friends and acquaintances. And thank you for allowing me to be part of this stimulating forum which, over the years, has been an important venue for debating ideas and facilitating agile intellectual interactions. It is a particular honor to be here today for the annual Homer Jones Memorial Lecture. Mr. Jones made important contributions during his illustrious career – principally here at the St. Louis Fed but also at Brookings, Chicago, the FDIC and Rutgers. He was committed to public policy and displayed leadership skills that are still admired today, some 25 years after his passing. And while I have questioned some of the assumptions that underpinned elements of Mr. Jones’ work and policy advocacy over the years, I have nothing but admiration for his willingness to question conventional wisdom and official doctrine, encourage researchers to think outside the box, and engage them in open and stimulating debates. Speaking of stimulating debates, the views that I will express today have been informed and influenced by the rich intellectual interactions that are conducted at PIMCO, my professional home. I am privileged to work in a place that embodies many of the qualities that Mr. Jones felt should dominate and persist in an institution that takes its analytical research seriously and is committed to getting things right even when this means being an outlier. The views that I will share with you are, of course, my personal ones and should in no way be deemed to reflect those of PIMCO as a firm or those of other people who work there. I wrestled with many topics in preparation for this event. In the process, I remembered the counsel given to me many years ago by a professor when I was trying to select the subject of my doctoral thesis. He advised me that, in order to maximize the probability of success, I should be guided by two principles: Make sure to cover issues where I know more than those who will be evaluating my work; and, in putting everything together, make sure that I mix and match among components that no one in their right mind would ever combine! I did not listen to this professor’s advice back in 1980, and I have not done so today. Indeed, I have gone the other way! And in so doing, I suspect that I will get very close to – and perhaps even cross, though I hope not – that delicate line that every speaker faces and fears: the one that separates courage from stupidity.2Today, I will ignore the professor’s advice in multiple ways. I will speak in a central bank and to central bankers about the role of their institutions – particularly the Federal Reserve and the European Central Bank – in today’s highly complex, perplexing and historically unusual policymaking environment. I will go further and try to link actions to motivations. And, when it comes to implications, I will attempt to put forward questions and hypotheses that, I believe, are critical for the future of the U.S. and global economies but for which I, like others, have only partial answers. I do all this for a reason. I believe that, whether you look at the U.S. or Europe, central banks have essentially been the only policymaking entities consistently willing and able to take bold measures to deal with an unusually complex set of national, regional and global economic and financial challenges. In doing so, they have evaluated, to use Chairman Bernanke’s phrase, an “unusually uncertain outlook;”3 they have confronted some unknowable cost-benefit equations and related economic and political trade-offs; and, in some cases, they have even had to make things up as they go along (including moving way ahead of other government agencies that, frustratingly, have remained on the sideline). The result of all this is a global configuration of previously unthinkable monetary policy parameters. While their immediate effects may be known, the longer term ones are less clear, and yet they are important for the wellbeing of millions around the world. Moreover, there is already evidence to suggest that the impact could well alter for years some of the behavioral relationships that underpin the traditional formulation and effectiveness of the trio of policies, business plans and financial investment positioning. Accordingly, it is critical that all of us – policy makers, business leaders, investors and researchers – work to understand why so many unthinkables have become facts, why the outlook remains unusually uncertain, and what changes are needed to limit the risks of further disruptions and bad surprises down the road. For those who are eager to get to the bottom line of my presentation, let me say right here that the analysis will suggest that central banks can no longer – indeed, should no longer – carry the bulk of the policy burden. This is not a question of willingness or ability. Rather, it is a recognition of the declining effectiveness of central banks’ tools in countering deleveraging forces amid impediments to growth that dominate the outlook. It is also about the growing risk of collateral damage and unintended circumstances. It is high time for other agencies, in both the public and private sector, to step up to the plate. They should – indeed, must – use their better-suited instruments to help lift impediments to sustainable non-inflationary growth and job creation. In other words, it is about improving the prospects for higher economic activity and, therefore, “safe de-leveraging.” This is not to say that central banks will no longer have an important role. They will. Specifically, in what may gradually morph into an increasingly bi-modal distribution of expected outcomes in some parts of the world (such as Europe), central banks could find themselves in one of two extremes: At one end, they may end up complementing (rather than trying to substitute imperfectly for) policies by other agencies that put the global economy back on the path of high sustained growth and ample job creation. At the other end, they may find themselves having to clean up in the midst of a global recession, forced de-leveraging and disorderly debt deflation. Finally, there is a real question about how the overall global system will evolve. Most agree that its Western core is weakened and multilateralism is challenged. As a result, the system is likely to struggle to accommodate the development breakout phase in systemically important emerging economies and absorbing the de-leveraging of finance-dependent advanced countries. What is yet to be seen is whether the outcome will be a bumpy transition to a more multi-polar global system, or the healing and re-assertion of a uni-polar one. The key hypothesis To crystallize our conversation today, allow me to use a very – and I stress very – clumsy sentence to summarize the current state of affairs: In the last three plus years, central banks have had little choice but to do the unsustainable in order to sustain the unsustainable until others do the sustainable to restore sustainability! To translate this purposely awful sentence:
As a result, talk last year about policy “exit” quickly gave way to an intensification of measures aimed at stimulating growth – be it the launch of another round of “unconventional” measures or the unprecedented use of communication. Indeed, as shown in Chart 5, the 2011-12 pivot in the FOMC narrative has been quite remarkable.
Interestingly, this was not related to the Fed’s ability to influence market valuations in a significant manner and for a substantial period of time. Indeed, the Fed has repeatedly been able to turbo-charge the equity markets and those for other risk assets (e.g., high yield bonds); it has also simultaneously influenced the market for U.S. Treasuries (Chart 6) via financial repression.11 The problem had to do with the transmission to the real economy. Despite higher valuations, the hoped-for impact on economic activity, be it through the wealth effect or “animal spirits,” has not materialized in the anticipated scale and scope.
To be effective, central banks in advanced economies needed – and need – help from other policymaking entities to deal with the twin unfortunate reality of too much debt and too little growth. They must be assisted with the engagement of the healthy balance sheets around the world, and fortunately there are quite a few of them in both the public and private sectors. And this must be done in an internationally coordinated fashion in order to accommodate the new global realities. Central banks have received very little help – coordinated or otherwise – from other policy agencies. Moreover, until recently, too many of these agencies were inadvertently complicating the tasks of central banks. The contrast reflects a handful of factors:
These national failures were compounded by weak policy coordination at the global and regional levels. Finger pointing replaced the harmony achieved at the G-20 meeting held in April 2009 in London. This was accentuated by a distinct lack of common analysis, as well as an IMF that is still too structurally impaired to fully step into the void. Europe was hobbled by an additional element – challenges to a “unified sovereign” process that results in cumbersome decision making among, first, the 17 members of the eurozone and, second, the larger EU collective. This political reality has severely delayed meaningful early progress toward dealing with problems that were not adequately considered in the establishment of the eurozone. And, as hard as it has tried, the ECB does not have the ability to influence what at times is a dysfunctional political discussion among the politicians. The outcomes: Benefits, costs and risks Put all this together and it should come as no surprise that, having spectacularly succeeded in avoiding a global depression, central banks have subsequently faced difficulties in delivering their desired economic and financial outcomes. Yet they essentially have continued on the same policy path, raising the question of whether they are subject to the trap of “active inertia.”
As argued by Dan Sull,12 active inertia has historically tripped many successful companies, and poses a constant threat to others. Faced with a paradigm shift, companies respond, but too often do so on the basis of what ends up being an outmoded and ineffective mindset. Importantly, what is at play here is not the inability to recognize a paradigm change in a timely basis; nor is it the lack of appreciation that action is needed. Rather it is the combination of such factors as inadequate strategic framing and inappropriate anchoring. The result is understandable difficulty in adjusting the set of approaches, procedures and conventional wisdoms that previously had served the institution well. Having succeeded in sharply curtailing the catastrophic risk of a global depression, the challenge for unusual central bank activism is now extending beyond the inability to deliver economic outcomes. There are also genuine concerns that such activism involves a range of collateral damage and unintended consequences, only some of which are visible at this stage. And there will be questioning whether all this continues to be justified by central banks’ impact on the overall economy. Already, there are visible changes to the characteristics and functioning of certain markets. As an example, consider what is happening to the money markets segment. With policy interest rates floored at zero for such an extended period of time (past and also prospectively, according to recent FOMC statements), this segment will continue to shrink – and will do so mostly from the supply side. Funds are being re-intermediated to the banking sector, with quite a portion ending up in excess reserves at the Fed. In the process, borrowers that previously depended on money market investors (think here of commercial paper issuers as an example) are having to find alternative sources of funding. The pension industry is also increasingly challenged. At current rates, the extent of underfunding is becoming even more systemic and is only being partially compensated by the increase in equity prices. This will serve to accelerate a discussion that will be held in many circles in advanced economies: how to deal with the host of promises that were made at a very different economic time and that can no longer be met fully. The functioning of markets is also changing given the size and scope of central bank involvement. The result is artificial pricing, lower liquidity and a more cumbersome price discovery process. Moreover, participants will tell you that there are signs that the intermediaries have shifted a meaningful part of their balance sheet availability – away from making markets for private sector clients to positioning for both the public sector’s primary issuance and buy back activities – a perfectly rational move given that the latter has more certainty at a time of general uncertainty. Every time central banks buy government bonds, they do more than take duration out of the marketplace (and credit/ default risk in the specific case of the ECB’s SMP). In the case of three institutions in particular (the Bank of England, the Bank of Japan and the Fed), they also change the balance between “safe” and other assets in the financial system13. This has implications for collateral flows and values, as well as market positioning. There are also implications for the behavior of market participants. The essence here was captured well in a recent investor remark reported by Bloomberg: “Investors are numb and sedated…. by the money sloshing around the system.”14 When we discuss the impact on the functioning of markets, it is important to remember that, in game theoretic terms, central banks are “non-commercial players.” Their motivations and objectives differ from those of other market participants that are driven by P&L considerations. They pursue non-commercial objectives; they possess a printing press at their command; and they have “structural patience” that far exceeds the ability of any other participants to remain in the trade. As such their large involvement in markets cannot but alter their functioning and what constitutes rational behavior on the part of participants. As demonstrated in the earlier chart (Chart 6), the previously widespread notion of a “Greenspan put” for equities has now been replaced with that of a “Bernanke put” for both equities and bonds. You will thus find a significant number of investors referring to the repeated revealed preference of the Fed as an indication that the institution is de facto committed to supporting asset valuations until they are warranted by fundamentals. In Europe, ECB-influenced moral hazard trades seem quite prevalent based on casual empiricism, and especially after the LTROs. Put differently, a view has evolved that the “trading” segment of markets, whose focus is understandably short-term, is now dominating the “investment” segment. This is consistent with data on market activity, how cash is allocated, and the succession of “risk on” and “risk off” sentiment. The problem with this for the economy relates to the risk that capital allocation is distorted on both sides of the Atlantic.I suspect that businesses and investment committees around the world are spending an unusual amount of time discussing what central banks are likely to do next. In too many cases, this discussion may overshadow those on fundamental trends, product design and relative value opportunities. In the meantime, the incentive to self insure against certain outcomes increases, making it harder to sustainably crowd in long-term capital.15 The recurring willingness of central banks to inject liquidity is also seen by some to be a contributor to higher commodity prices, especially oil and precious metals – if not directly, then indirectly by encouraging a move of financial investments into the “real asset category” which also includes TIPs (see Charts 8 and 9 for related move in inflation breakevens and real rates). As real and perceived risks of liquidity-induced inflation rise, a larger number of investors also opt for commodities as a hope for protecting real purchasing power. As a result, in targeting “good inflation” (namely, higher asset prices that, in turn, lead to greater investment and consumption and, accordingly, better economic outcomes), central banks have been accused of contributing to “bad inflation” (including stagflationary headwinds caused by higher commodity prices) and, ultimately, greater challenges to consumption, investment, growth and job creation.
Whether in the U.S. or Europe, government yield curves are essentially floored at exceptionally low rates up to around the five year point (arguably the segment of the yield curve that has the most impact on economic activity). It is also increasingly uncertain whether, at the current set of market valuations, central banks can rely just on asset purchase programs as a means of enticing investors into doing things that they would not be doing on the basis of fundamentals. Sustainability for investors is more a function of being pulled into an investment due to its inherent attractiveness rather than being pushed into it by central banks’ artificial manipulation of relative prices. Finally, there is the political angle. The unusual activism of central banks, and especially components that are viewed to come close to quasi-fiscal operations, are naturally attracting greater attention, including calls to de facto (and in some cases de jure) subject them to greater parliamentary oversight.22 All this comes at a time when we should expect the collateral damage of central bank activism to increase. As noted earlier, this is a multi-faceted issue, involving the wellbeing of certain sectors, the viability of historic contracts and perceived entitlements, and the very functioning of markets. And while we do not know where the exact tipping points are, few wish to get too close to them. To put it bluntly, there are now multiple reasons to worry about central banks' expensive (and expansive!) policy bridges risking to end up as bridges to nowhere. In other words, there is a growing possibility that, absent mid course corrections, unsustainability may be the common characteristic of the central banks’ unusual policy activism. Please recall the earlier discussion (Page 5) of the seven dynamics driving the fundamental structural realignments facing advanced economies. This is the economic context in which central banks need to pivot from the unsustainable to the sustainable. And to do so, they urgently need the cooperation of other government agencies that are better placed to address what are increasingly structural impediments to growth, jobs and better income and wealth distribution; and they need positively correlated behavior on the part of the private sector.In the U.S., Fed measures need to be supplemented by actions in the following key areas: the labor market, public finances, housing and housing finance, credit intermediation, education and investment in social sectors and infrastructure. For the sake of brevity, let us focus here on a subset. While the unemployment rate has come down in recent months – and we can argue endlessly about how much was due to genuine job creation rather than an avoidable decline in the labor participation rate – it is hard to deny that the structural rigidities are considerable, persistent and consequential.23 Recall that, according to the Bureau of Labor Statistics, the number of long-term unemployed in the U.S. has been stuck at around 5 ½ million.24 The longer the duration of joblessness, the greater the risk of skill erosion and the greater the headwinds to productivity and prosperity. Or note the worrisome indicator of youth unemployment. Some 24% of 16 to 19 year olds in the labor force are unemployed: At that age, persistent joblessness can turn someone from being unemployed to being unemployable. Or note the sharp dispersion in the unemployment rates for different levels of education: from 4% for those with bachelor degrees to 13% for those without a high school diploma. Central bank actions cannot deal with these issues. Simply put, these institutions do not have the instruments or expertise to deal with the challenges of labor training and retooling. They cannot improve labor market flexibility and mobility. And they cannot impact the country’s education system. Yet these challenges should, indeed must, be successfully confronted if we are to avoid the curse of unemployment becoming deeply embedded in the structure of the economy and, therefore, much harder to solve. Put housing and housing finance in the same category of importance as the labor market. There will be no durable and healthy economic recovery unless America deals with an issue that affects wealth, labor mobility, market clearing dynamics, the rule of law, and the willingness of fresh capital to engage. Once again, there isn’t much that the Fed can do beyond advocacy (something that it has been doing via speeches and a white paper).25 We all have to look elsewhere for an actual set of durable and effective policy measures. Then, of course, there is the state of public finances. This is critical to both the immediate and longer-term well-being of the country.
1 CEO and co-CIO of PIMCO. The views expressed in this paper are his alone and do not represent those of PIMCO. I would like to thank my PIMCO colleagues for the wonderful interactions and thought-provoking discussions over many years. Special thanks to colleagues who offered me suggestions and/or commented on this paper, including Francesc Balcells, Andrew Balls, Andy Bosomworth, Rich Clarida, Bill Gross, Scott Mather, Saumil Parikh, Lupin Rahman, Josh Thimons, and Ramin Toloui. 2 I am grateful to Paul McCulley, my former PIMCO colleague, for first alerting me of this delicate balance. 3 Mr. Bernanke warned of the unusually uncertain outlook during his July 20th, 2010 appearance before the Senate banking, housing and urban affairs committee. 4 Mr. Bernanke referred to this balance – between benefits, costs and risks – in his 2010 Jackson Hole paper; Bernanke, Ben (2010), The Economic Outlook and Monetary Policy, the Federal Reserve Bank of Kansas City Economic Symposium, Jackson Hole, Wyoming, August 27th, 2010. He also cited the balance in subsequent papers and testimonies. 5 FOMC Press Release, January 25th, 2012. 6 El-Erian, Mohamed A. (2012), The Fed Explains its Big Adventure Financial Times, February 16th. 7 The concept of sudden stops was popularized by Professor Calvo in the context of the 1980s Latin American crisis. See Calvo, Guillermo (1993), Explaining Sudden Stop, Growth Collapse, and BOP Crisis, IMF Staff papers, Vol. 50, IMF, Washington, DC. 8 This paper does not deal with the role of central banks in the run-up to the 2008 global financial crisis. 9 Blanchard, Olivier (2011), Blanchard on 2011’s Four Hard Truth, VOX, December 23rd. 10 El-Erian, Mohamed A. and A. Michael Spence (2012), Systemic Risk, Multiple Equilibria and Market Dynamics – What You Need to Know and Why, PIMCO Viewpoint, March. 11 Reinhart, Carmen and Kenneth S. Rogoff (2009), This Time Is Different: Eight Centuries of Financial Folly, Princeton University Press. 12 E.g., Why Good Companies Go Bad, Harvard Business Review, July 1999. 13 Barclays (2012),Equity Gilts Study, Barclays Capital, February 8th. 14 Detrixhe, John and Flavia Krause-Jackson (2012), Iran Anxiety No Match for Central Bankers Sedating Investors, Bloomberg News, February 8th. 15 Note that all this is consistent with the changes in asset class correlations in capital markets. 16 See, for example, the comments by Finance Minister Guido Montega reported in Financial Times (2011), Trade War looming, Brazil Says, January 10th. 17 Lyons, John and Bon Davis (2012), Emerging-Market Engines Falter, Wall Street Journal, March 8th. 18 Wolf, Martin (2010), Why America is going to Win the Global Currency Battle, Financial Times, October 12th. 19 See Shirakawa, Masaaki (2012), Deleveraging and Growth: Is the Developed World Following Japan’s Long and Winding Road, Lecture at the London School of Economics and Political Science, January 10th. See also El-Erian, Mohamed A. (2011), Learning from the Lost Decades, Reimagining Japan.20 See, for example, Gross, Bill (2012), Life or Death proposition, Investment Outlook, PIMCO; and Gross, Bill (2012), Zero-based money is at risk of trapping the recovery, Financial Times, February 6th, 2012. 21 See also Raskin, Sarah Bloom (2012), Accommodative Monetary Policy and Its Effects on Savers, Speech to the Y’s Men and Y’s Women of Westport, Westport, Connecticut, March 1st. 22 For a recent analysis of concerns with activism, and for the case for restoring some of the old orthodoxy, see Plosser, Charles I. (2012), Restoring Central Banks after the Crisis, Speech to the Inaugural Meeting of the Global Society of Fellows of the Global Interdependence Center, Banque de France, Paris, France, March 26th. Part of this perspective is countered in another paper presented at this meeting – namely, McCulley, Paul and Zoltan Pozsar (2012), Does Central Bank Independence Frustrate the Optimal Fiscal-Monetary Policy Mix in a Liquidity Trap. 23 For example, see El-Erian, Mohamed A. (2012), Still Losing the War on Unemployment, Washington Post, February 5th. A more detailed recent analysis is contained in Bernanke, Ben S (2012), Recent Developments in the Labor Market, Speech to the National Association for Business Economics Annual Conference, Washington, DC, March 26th. 24 BLS (2012), The Employment Situation – January 2012, February 3rd. 25 Board of Governors of the Federal Reserve (2012), The U.S. Housing Market: Current Conditions and Policy Considerations, Washington, DC. 26 As an example, please see Schroeder, Peter (2012), Bernanke Warns Lawmakers Country Headed for Massive Fiscal Cliff, The Hill, February 29th . 27 For example: Clarida, Rich (2011), Uncertainty Changing Investment Landscape, PIMCO Viewpoint, August; and Bhansali, Vineer (2011), Asset Allocation and Risk Management in a Bimodal World, PIMCO Viewpoint, December.
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