Mohamed El-Erian on the market: ‘We have lost our most important anchor’

Mohamed El-Erian, president of Queens College, Cambridge University, and Allianz Chief Economic Advisor, joins Yahoo Finance Live to discuss surging inflation, markets, and how the economy will react to the Fed's decision.

Video transcript

JULIE HYMAN: As Ines just pointed out, all of these headlines coming out on Ukraine and Russia, it's a very fast-moving situation, a lot of conflicting headlines. And the market has been very sensitive to those headlines. So let's get some perspective on this as well as, of course, perspective on the Fed and inflation.

I want to bring in Mohamed El-Erian, he's President of Queens College at Cambridge University and Chief Economic Advisor at Allianz. Mohamed, it's always great to see you. You know, we've been through a lot of market cycles, right? And we have seen geopolitical conflicts before or threats of conflicts that don't really seem to affect US equity markets. This one feels a little bit different. Is that because of the nature of the conflict or the nature of markets right now?

MOHAMED EL-ERIAN: It is both. The conflict itself, if it were to get worse, which is a big if, but if it were to get worse, would blow a very strong stagflationary wind through the global economy. So that factor is something that the markets are keeping an eye on. But there's also something else, as you rightly point out. We have lost our most important anchor.

For a very long time, this market had the anchor of a very accommodating liquidity regime. Inflation changes all that. We can no longer depend, and rely, and predict massive injections by the Federal Reserve. And once you take that anchor away, you're left with a corporate earnings anchor. And that one is significant. That's why, actually, markets have behaved relatively well. But it's nothing like the bigger one that has gone away, which is this continued injection of liquidity.

JULIE HYMAN: I do want to pick up on that, but first, follow up on the first comment you made about Russia-Ukraine maybe presenting a stagflationary threat to the markets. We've seen the effect on oil prices, right-- pushing oil prices up because of concerns about supply. Is that your primary concern here regarding that and then the knock-on effects of that? Or are there other elements that we should be considering?

MOHAMED EL-ERIAN: So it's more than oil. If you look at Russia and Ukraine, they are major exporters of a number of commodities. And if a conflict were to break out, a military conflict, then you would have sanctions that would limit exports from Russia. And you would have disruptions in Ukraine.

So the first element is simply a big cost push. Second, you would have a significant blow to sentiment, confidence, and a further blow to globalization. So that's why this is a significant thing to look at. The marketplace right now is pricing somewhere between we get a good diplomatic resolution or we stay in this uncomfortable no war and no peace.

We're not really pricing in the possibility that this may be an armed conflict. I understand why that's the case, because most people think it's not going to happen. But that explains also why the market is so sensitive when there's news of some sort of problem, if you like, on the ground.

BRIAN SOZZI: And, Mohamed, if the situation does escalate, you could very easily get oil prices well over $100 a barrel-- gas prices $5 to $6 a pop. Is that recession worthy for this year?

MOHAMED EL-ERIAN: It would certainly, as I said, have this stagflationary wind. Does it mean recession automatically? I don't think so-- certainly not for the United States. It will be more problematic for Europe, because you'd also get supply disruptions on top of the price hit. But I think for the United States, don't underestimate the resilience of the US economy.

I think the biggest risk to the US economy is a Fed policy mistake. That is the biggest risk.

JULIE HYMAN: Well, that's something we've talked a lot about before, Mohamed. So take me to the March meeting of the Federal Reserve. Do they need to raise by 50 basis points?

MOHAMED EL-ERIAN: It's a really tough question. You know, one of the problems of being so far behind-- and that's why you've heard me for the last nine months say, be careful. The Fed is falling behind-- is you no longer have the best policy, it's your least bad policy. And you've got to make difficult judgments.

They could hike by 50-- the argument being move in a bold manner and try to regain the policy credibility that you've lost. The problem is that they may end up pricing in subsequent increases of not 25, but 50. What if they just keep 25? While the market may be at first relieved that we didn't get more of a hawkish response, but very quickly they're going to figure out that persistent inflation is an issue and increases the probability of the Fed slamming down the brakes down the road.

So we have this issue now that we're in the world of second-best. And there's going to be really delicate judgment calls to be made.

If it were me, I would try to regain the policy narrative by only doing 25 and being very clear on what comes next. But I wouldn't validate seven rate hikes. I think that's too much for the US economy.

BRIAN SOZZI: Mohamed, these rate hikes, when do they start impacting the US economy? Even a 25 basis point hike in March, it's still raising interest rates. What's the economic effect of that?

MOHAMED EL-ERIAN: So the direct economic effect should be small. We're starting from very low levels. Liquidity is still abundant. I mean, even today, the Fed is still injecting liquidity. We have an inflation rate of 7.5%, and the Fed is still injecting liquidity. That doesn't stop until next month.

So it's still a very liquid environment. The concern, Brian, is that there's also QT around the corner. And the market hasn't quite figured out how do you price QT. So put QT on the side, saying we'll get to that later. And that's why you've had a repricing of the interest rate complex without any disruptions.

When you start playing around with liquidity, then it becomes more challenging. So the answer to your question is no one knows, because we haven't had a situation where we have significant QT and higher rates coming at a time when the market has been accustomed for so long on zero interest rates and just massive injections.

BRIAN SOZZI: But do you think, Mohamed, a 25 basis point hike in March, would that do anything for inflation? Because as you know, we're seeing this inflation because we're still in the middle of a global pandemic.

MOHAMED EL-ERIAN: Yeah. I mean, people confuse this all the time. They say the major problem-- supply disruption, labor shortages-- the Fed can't do anything about it. That's absolutely right. But historical episodes of inflation happen in the following way. There was some shock to the system. In the '70s, was the oil price increase.

Then next thing you know, the inflation process becomes much broad-based. That's what's happening today. And then inflationary expectations get de-anchored. What do I mean by that?

In a perfect world, you want people to say this inflation is truly transitory. I don't need to change my behavior. But because inflation has stayed high for so long, people are changing their behavior. They're asking for compensation, higher wages, companies are raising prices.

That is all adaptive. You're adapting to what has happened. The really dangerous phase is anticipatory-- when you feel that to protect your purchasing power, to protect your profit margins, you need to protect against future inflation. And that's what the Fed can help avoid is that inflationary expectations become a main driver of inflation.

We're not there yet. But if the Fed is not careful, we will get there. And that's why it's important for it to show that, A, it understands the inflation dynamic, because right now, it has very low inflation credibility because it got the call wrong for so long. And then second, that it regains control of the policy narrative.

JULIE HYMAN: Mohamed, something else that we've talked a lot about is something-- you know, people keep saying we haven't had inflation for years. Well, we had asset inflation for years, right, of all different types. And we have started to see that come down in anticipation of what the Fed is going to do-- you know, stocks with lofty valuations and the private markets to some extent, crypto has come down to some extent. As the Fed actually embarks upon its raising and tightening cycle, what do you think the effect is going to be on all of these assets where money has just been pouring in over the past several years?

MOHAMED EL-ERIAN: So it should come as no surprise to people that we've had some pullback. When the buyer, the most reliable buyer, with their own printing press and an incredible willingness to buy-- when they step out of the market, that is a fundamental change to the marketplace. So it shouldn't come as a surprise that we are lower, because $120 billion a month of asset purchases are disappearing.

Now, that need not be disorderly. If you can establish and you still have strong fundamentals, people will come in and take the leg up based on something much more lasting than a liquidity regime. The concern we have is by being late, the Fed also puts economic growth in play. And that means earnings become more uncertain. So that's why this is a very delicate period. There is still a window to get this right. But unfortunately, that window is closing. And the last set of data, the CPI, the PPI, and the retail sales just give you a sense of how far the Fed is and how much more difficult it will be to get a soft landing.

JULIE HYMAN: We're all holding our breath, so to speak, amidst all of this. Mohamed, good to see you. Thank you so much. Mohamed El-Erian, President of Queens College at Cambridge University and Chief Economic Advisor at Allianz. Thank you so much.