Mohamed El-Erian, president of Queens' college at Cambridge University and Allianz chief economic advisor, joins Yahoo Finance to discuss the latest Fed decisions, impacts from bond market moves, and inequality due to the pandemic.

Video Transcript

- Let's keep on this topic and talk more broadly about everything happening with the Fed and the markets. We bring in Mohamed El-Erian. He's the President at Queens College at Cambridge University and Allianz's chief economic advisor. Mohamed, always great to speak with you. So let's begin with your initial thoughts from Powell's press conference yesterday and the trajectory that you see him laying out for Fed policy as this expansion continues.

MOHAMED EL-ERIAN: So when do you think of it, we came out with three things that hardly ever coexist at the end of the meeting. One is a significant revision in the Fed policy and the Fed economic outlook on inflation. As Brian just said, they hiked their growth expectations significantly to 6 and 1/2%, and they hiked that PCE, both overall and core. So for one thing, it's a much better economic outlook.

Second, absolutely no change in policies. In fact, if you compare this statement to the prior one, there were hardly any changes. Third, a calm bond market. Those three things hardly ever coexist. And what we saw this morning is that it's the bond market that has said, hey, wait a minute. If the outlook for the economy is that much better and the Fed isn't going to do anything about it, do we risk inflation? Do we risk disrupting the liquidity paradigm that has served us so well?

So you see the influence. Why did it come the next morning? I think it had partly to do with market positioning. The bond market went into the Fed meeting quite short. But I think that the Fed has a really difficult situation here. It may lose control of the bond market, and it has to be careful.

JULIE HYMAN: Mohamed, it's Julie here. It's good to see you. I mean, the Fed said that inflation was coming, right? That's what it's been saying. But the inflation is not going to last. Is there a way that the bond market would even price in temporary inflation? Does it-- does it really have that ability?

MOHAMED EL-ERIAN: So the Fed-- the Fed's view is that inflation is transitory, and that's the word they keep on using over and over again. You know, the Fed tends to think as an economist. The market-- and economists look through changes over time. Markets tend to live more in the moment.

So if inflation is going up-- and look at the breakevens. The breakevens are at 2.64 for the five-year. If inflation is going up, the marketplace is saying, I'm not so sure it's transitory. Prove to me it's transitory. And that's the difficulty the Fed has. We are seeing supply bottlenecks multiply. And for me, I do think inflation will go up. I do think it's not going to be a permanent inflationary process. But the market is not going to look through that as easily as the Fed would like it to.

- Mohamed, the inflation you're suggesting that is coming, is that-- do you think that's going to be bad for stocks?

MOHAMED EL-ERIAN: So if it was coming on its own, no, it wouldn't be bad for stocks. The problem are the initial conditions. And the problem is that we have a marketplace that is psychologically reliant on the Fed. And if the Fed is no longer in control of the bond market, a few things happen. One is you fundamentally shake the confidence in the liquidity paradigm. Secondly, the TINA effect-- there is no alternative to the stocks. Well, you know what? As yields head higher, there may be an alternative to stocks. So that holds back the buy the dip conditioning that has been so helpful to markets.

And finally, look for algos in particular. Look for model-driven flows to start being less bullish about the equity market. Why? Because discounted cash flows are going to look different. So it is an issue for the equity market why-- why it is that the economic outlook both on growth and inflation is changing.

- Well, and Mohamed, maybe to put a finer point on this, something that we've talked about here on the show is the idea that the economy can do quite well, and that could actually be negative for certainly risk markets. Is that a kind of dynamic that investors should be on the outlook for? And how might one position around that kind of situation?

MOHAMED EL-ERIAN: Yes. I mean, it's the opposite of what we've had. You know, we've had a very unusual situation where the economy was struggling and you made money, both on your risk assets-- stocks, NASDAQ, et cetera-- and on your risk-free assets, government bonds. That's what we did last year, and it was wonderful.

Now there's a risk that this thing goes into reverse. The economy does well. It shakes-- undermines the liquidity paradigm, and both stocks and bonds lose money. I tell people, if you like it or not, you're making-- you're taking a view on three things. Just be clear what views you're taking.

One is, will the Fed lose control of the bond market? Two is, will this completely change the psychology of the market? Three is, will this spillover in a negative way to the marketplace, to the economy? My view is the Fed risks losing control of the bond market. Two is it will shake the liquidity paradigm. But three, it will not harm the economy. The economy is all about pent-up demand, fiscal stimulus, and COVID. That's what's going to determine the economy, not what happens in the bond market.

JULIE HYMAN: And so that also suggests, then, that there is still some-- going to be some opportunities in the market for companies that can withstand this. And it's striking to me, in one of the pieces that you wrote recently, as a macro guy, you basically seem to be advocating for some stock picking in this environment, you know, getting a little bit more specific and choosy about where your investments should be at a time where the broader market may be a little bit more turbulent. And you're looking at criteria like strength of balance sheets, for example.

MOHAMED EL-ERIAN: Yes, absolutely. I think for a long time, it was a macro call. Get the Fed and liquidity right, and you don't really have to care about much else, as long as you avoid bankruptcies. And that's why passive index investing did so well. Now is-- I think it's going to be an environment for very active management, building portfolios from a bottom-up perspective, and making sure that you have robustness to changing liquidity and economic paradigms.

So you've got to come up with a mix that is resilient to a change in the liquidity paradigm but takes advantage of what I think is going to be a significant economic pick up. My own view, Julie, is that unless we get a big slippage on the battle against COVID-- and we've got to be careful-- we're looking at an economy that's going to grow in excess of 7%. The Fed is going to have to revise its growth projection up again. So that is quite an economic pick up, and a very welcomed one for Americans.

- Mohamed, there's a lot of-- there's millions of people waking up this week with stimulus checks in their bank account. And it stands to be a lot of money for some households. How would you invest your stimulus check if you were getting one?

MOHAMED EL-ERIAN: That's a really hard question. You know, and the way it's been done in the past is go for the most volatile assets because they will do best when liquidity is sloshing around and when people are stretching for yield. And that serves people extremely well. You know, I've talked to you before. If there's a massive liquidity wave that's not going to break, ride it. Surf it. That's the right thing to do.

Tactical mindset, not a secular or structural mindset. Tactical mindset, but you have to respect liquidity. Now it's much harder. It's much, much harder. So I go back to what I just said to Julie, is you've got to be sure you're picking names properly. This is not a time to simply throw or to invest your stimulus funds in the most volatile assets.

JULIE HYMAN: Mohamed, finally, you have written on inequality, and the Fed has given a lot more attention to that issue as of late. The policy right now, how are they doing in terms of attacking inequality? Which, as we know, is a problem that's much larger than what the Fed could potentially address. But of its part in it, is it doing what it can?

MOHAMED EL-ERIAN: So it's a huge problem, because what we've seen is that COVID is the great unequalizer. It has made the inequality of income and wealth worse, and it has hit the inequality of opportunity. So a year later, we have high inequality across the board-- income, wealth, and opportunity. And opportunity, in particular, is a huge problem.

Look, the Fed is in a difficult situation because its policies have inadvertently contributed to wealth inequality, not by choice. The Fed has been operating through the asset channel. Boost up asset prices. Who owns the assets? The richest Americans. So the Fed ends up inadvertently by worsening inequality. That is why it is focused so much on this.

Unfortunately, there isn't much it can do. It can try to run the economy even hotter, and that's what the Fed is trying to do. But there are consequences to that. This is up to fiscal policy. And I think we've seen a first set of measures aimed at trying to reduce income inequality. The next step has to focus on improving the equality of opportunity. Opportunities are critical. Otherwise, we end up with a lost generation of young people.

- All right, six years later, and I think the theme of your book, Mohamed, still rings true. Only game in town. Not going to last forever. Policymakers starting to-- to finally understand that, I think, a little bit in some changing tides here in fiscal and monetary policy land. Mohamed El-Erian, always appreciate the time. Thank you so much for hopping on this morning, and I hope we'll talk soon.