Chief Economic Advisor, Allianz
Mohamed El-Erian's Fed warning
The biggest question facing the Federal Reserve may not be whether it cuts or raises rates.
Mohamed El-Erian explains why he believes the Fed is undergoing a much bigger transformation after years of policy mistakes, what that means for investors, and why debates over interest rates may be distracting from the real story.
The conversation also explores AI investment, market leverage, tech valuations, and why public trust could become AI's biggest challenge.
Timestamps
00:00 The Fed rate debate
00:46 Why opinions are split
01:08 Why the Fed stays put
02:07 Breaking Fed dependence
02:40 Measu...
About Mohammed El-erian
Mohamed El-Erian, chief economic advisor at Allianz and a professor at the Wharton School, has stated he expects the Federal Reserve to keep interest rates unchanged for the remainder of the year, a position he described as a "strong expectation." He characterized the Fed as undergoing a necessary transformation after years of policy mistakes, including its 2021 characterization of inflation as transitory and issues with compliance and forecasting. El-Erian also said the Fed is likely "tolerating a 3% target" rather than its stated 2% target. He noted that the ECB's rate hike was appropriate given its single mandate, whereas the Fed, with a dual mandate, should wait. Regarding inflation, El-Erian said "the worst of inflation is behind us" and that it will likely peak in mid-2025. He linked remaining inflationary pressures partly to AI-related investment, which he described as having a positive supply-side effect. On AI, El-Erien said its productivity potential "can be more than Greenspan," but warned the industry has a "massive PR problem" and that more attention is needed on adoption and diffusion. He called tech valuations a "rational bubble," arguing that over-investment is a less costly mistake than under-investment. El-Erian expressed concern that the bond market cannot fund the combined needs of AI investment, government deficits, and corporate borrowing without higher yields, asking rhetorically where the funding will come from.
Transcript (21 segments)
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Interviewer0:00
As we were just discussing, there is perhaps an unusual difference of opinion on whether the Federal Reserve is going to raise rates or not this year. And let's talk more about that. Joining me in studio is Mohamed El-Erian, Allianz chief economic advisor and professor at the Wharton School. Always great to have you, especially to have you in person. Thanks for being here. It does feel unusual how divided people are. I mean, I just talked to a strategist a few moments ago who said, 'There's no way that...' She said it's nuts that people think the Fed is going to hike this year. And then I talked yesterday to Diane Swonk of KPMG who said, 'Yes, they have to hike this year.' Is it because we are not getting more of a framework from the Fed? Why is there so much arguing about this right now?
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Mohamed El-Erian0:45
First, thanks for having me. And it is amazing. Bank of England says... Bank of America says three hikes. Quite a few people say cuts. I'm in the no change, so that you know where I am. Look, there are differences that relate to a few things. One is how people interpret the inflation numbers. Yesterday we had the PCE inflation, viewed as the Fed's favorite inflation measure. You have those who said, 'You know what? In line to somewhat softer and will come down. In fact, we may be at peak inflation.' You have those who said, 'Absolutely not. Look at core, it's going to continue to go up.' Then you have the change at the Fed, and people are wondering what that change means. And then you have different interpretations about the economy. Some see it as extremely strong. Others see it as strong in certain places, but weak elsewhere. I think if we put everything together, my strong expectation, not weak, strong expectation is the Fed does nothing this year. And the most important thing to focus on is the five areas that the new Fed chair, Kevin Warsh, has identified as needing work, because they really do need work. And the long-term effectiveness of the Fed will depend on addressing these issues, which have translated into major mistakes over the last 5 years.
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Interviewer2:07
But it also means we'll have to wait to get more clarity. It sounded like from what he was saying, it's going to take at least till the end of the year until those task forces really start to come out with some findings from their work. And so perhaps that supports your view that the Fed doesn't do anything in the meantime, but it also means the market has to sort of keep wondering, right?
M
Mohamed El-Erian2:26
Yeah, and I think that what Kevin Warsh is trying to do, and I think it's the absolutely right thing, is break this very unhealthy interdependency that developed between the markets and the Fed. And it resulted in the Fed seeing its room for maneuver reduced. That's not a good thing. And it resulted in the markets being very data-dependent, very short-term. And we've seen significant changes in expectations of rates. I think breaking that interdependency is in the interest of the economy longer term.
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Interviewer3:00
There's a lot of debate among other things, and this is one of the things that the task forces are going to address: how do we measure inflation? And there's some talk about trimmed mean inflation as one of the ways to measure it, but there's a lot of debate about that measure as well, that it doesn't anticipate sort of changes, regime changes in inflation. And so what is the best way to then measure inflation? How should the Fed be doing it? How should we be doing it?
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Mohamed El-Erian3:25
I'm not in favor of coming up with a whole host of inflation numbers. I think there is a more basic issue, which is the sources and uses of data. What data we're actually looking at. Is it concurrent data? Is it really stale data or not? And the second issue is the monetary framework. You know, very few people talk about the fact that the 2020 framework was dead on arrival because it was so backward-looking. And the 2025 framework was never completed. So, this is a Fed that's going to be revamped in a major way. And I think that is more important than whether they keep rates unchanged, cut, or hike. That is going to be determined by where the economy goes and where markets go.
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Interviewer4:09
Where does the balance sheet size fall into the equation? Because there's been talk that even if they don't change rates, Warsh, as he has talked about before, might try to shrink the balance sheet.
M
Mohamed El-Erian4:22
My understanding is what he wants to do is to have a theory underpinning balance sheet management before he does anything. You know, whether you like it or not, we talk about our star, some sort of equilibrium interest rate. No one has a clue on the analytics of an equilibrium balance sheet. And we've increased the balance sheet from 2 trillion to 9 trillion, back to 6 trillion. These are massive moves. And we've done that without an underlying theory of how the balance sheet should be managed. I think it's striking if you look at the Fed of the last 6 years, it went to sleep, of course, on policy, making the big mistake in 2021 calling inflation transitory. It went to sleep on forecast. It went to sleep on compliance. We had five senior officials. It went to sleep on balance sheet management. And I think what you're seeing is a major revamp of the Fed.
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Interviewer5:16
And it sounds like you think a necessary one.
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Mohamed El-Erian5:18
I think it's not just necessary, I think it's been long delayed. We need it urgently.
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Interviewer5:24
I want to turn to what's happening in tech stocks recently. We've been talking a lot about this. And whether it is a bubble. And if it's not a bubble, what do we need to worry about when we're looking at how these things have been trading?
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Mohamed El-Erian5:39
The economist in me thinks it's the most wonderful thing in the world that the capital markets are willing to fund innovation at the scale that they're willing to fund it. That makes the US unique in the global economy. The financial side of me says it is a bubble, but it's a rational bubble. In the sense that if you don't know which of these platforms, which of these applications is going to prevail, you have to have a venture capital mindset. You have to spread your bets, hoping that the one that works pays for all the losses elsewhere, because what's at stake is huge. Which means that when we look back and say, did we really invest that much in this company? I think more generally, we lived in a period where fundamentals, valuations, and technicals were all aligned for tech. And we saw the most amazing run. That put valuations out of whack. When valuation got out of whack, technicals got out of whack, and that's what we're seeing today. It's technicals that are undermining the tech trade. Fundamentals remain sound. So, I think this is more a temporary setback than a permanent one, and it comes from the fact that the valuations got completely out of whack.
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Interviewer7:00
How concerned are you about speculation and leverage in the system right now?
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Mohamed El-Erian7:05
I am worried about the leverage in Asia. You know, we don't talk about it there. Korea and Japan. I mean, if you look at what's been happening in those markets this week, your worry. So, the bad news is I think there's a ton of leverage that is excessive. The good news is that the spillover is going to be limited to markets and not the economy. And that's really, really important. You know, we're living in a world where we're concerned about markets. But actually the economy for once has lots and lots of tailwinds, including as someone spoke about in the recent segment for the bottom part of the cake. You have low energy prices. You have a strong labor market. You have lower borrowing costs. It's really nice to have these headwinds turn into tailwinds for such an important segment of the population. For a very long time the markets were fine, the bottom bit of the economy wasn't. It's good to see the bottom bit of the economy doing well.
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Interviewer8:06
When we are so reliant though on the economic front, we're very reliant there on the AI build-out as well. It's accounting for a much higher percentage of GDP than it was in the past. So, how worried are you about something there going wrong? Even in the financial markets, yes, if you have losses in one place you can be made up for by gains. But economically it doesn't necessarily work that way. If you've got a data center that you're building and then the demand for that data center drops, for example, do you have somebody else to come and take it over? Does that just sit vacant? Do you have that sort of economic build-out that then goes bust at some point?
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Mohamed El-Erian8:46
I think you have a short-term issue and a long-term issue. The short-term issue you captured perfectly when you called it the knives. The notion of an air pocket between build-out and monetization. The longer-term issue is every single innovation ends up overdoing it in the first phase. And the behavioral aspects are very simple. When you suddenly reduce the barriers to entry to something that's really exciting, we humans overproduce it and overconsume it. It happened in the Industrial Revolution. It happened with railroads. It happened with fiber optics. Every single time that happens. So, yes, are there going to be some data centers that are not going to monetize the investments? Yes, there are. But again, for the longer-term economic well-being, I'd rather we overinvest in fundamentally transformational innovation than do what Europe is doing and underinvest. Because longer term, the mistake of overinvestment is much smaller than the mistake of underinvestment.
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Interviewer9:49
And there's a concern now that because of public resistance to the build-out that we may be slowing down.
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Mohamed El-Erian9:55
Yeah, I mean AI has a massive PR problem. Massive. And they've got to realize they're systemically important. And they have to be out there with stories. Google does it really well. It says, 'Look, I can change the health sector. I can change education sector. Agriculture. Farmers now can have in their hand a tool that identifies much better whether their crop has disease or not and what the weather is like going forward. You go to developing countries, it's amazing that in rural Malawi, you can have a clinic that now has access to world-class medicine. You can have a school where a student has a personalized tutor.' I think the AI industry needs to tell these stories because the backlash is starting to build up in a major way.
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Interviewer10:48
Yeah, and it will become material potentially at some point.
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Mohamed El-Erian10:50
Yeah, absolutely. And it's going to become political as well.
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Interviewer10:52
Yes, definitely. Mohamed, thank you so much. It's great to see you.