Ratings agency Fitch surprised a lot of people when it downgraded its rating on U.S. debt from AAA to AA+. Allianz Chief Economic Advisor Mohamed El-Erian tells Yahoo Finance Live that he was surprised by the move too, and that "what Fitch put in their statement has been true for a while, so why now?" "When you look at the reason you scratch your head as to the timing of this," El-Erian said. On the political issues the downgrade could raise, El-Erian says "domestically, this is likely to fuel more of the polarized conversations that are going on. Internationally, for the adversaries of the U.S., they will point to that as yet another development in terms of the U.S. no longer being as powerful and as influential," adding that he thinks those arguments are "weak, but they will be used."
Overall, El-Erian says there is "no reason for the U.S. to fall into recession," saying the economy is "vibrant enough, it is flexible enough, and it's handling this global soft patch well." His biggest worry is that the Fed will overtighten and "continue pursuing an inflation target, 2%, that makes less sense for today's structural and supply-side elements." El-Erian says he wouldn't have hiked rates in July and "certainly wouldn't hike in September." "There's a more fundamental issue, which is, as I regard, excessive data dependency by the Fed," El-Erian said, highlighting how data is backward looking while the Fed's tool, interest rates, can take time to have an impact.
Joining us now Mohamed, El-Erian, Allianz's chief economic advisor. And Mohamed was formerly CEO and co-chief investment officer at PIMCO. He's also the President of Queens College Cambridge. It's great to talk to you, as always, Mohamed.
You said in a tweet that you were puzzled certainly by the timing of this. I wonder, though, if you are as puzzled by the fundamental case that Fitch is making here, that there is so much dissent that this is really holding back the US from a fiscal perspective.
So surprise but then expecting the market to brush it off, which is exactly what has been happening this morning.
- It has been happening to some extent, but we are starting to see yields creep up a little bit more. I saw a headline there at the highest now since November. So again, yes, why now, I get that argument. But how much of a problem is the descent in the US? And there's even been reporting that the team at Fitch was really spurred, although again very late, by the events of January 6th and sort of what that symbolized about what was happening in this country.
MOHAMED EL-ERIAN: So January 6 is a long time ago. So to be spurred now by something that happened two years plus ago is a bit surprising. Look, yields are going up for good reason. And it started before the Fitch announcement, and it's continuing. And the good reasons are twofold.
One is that consensus has revisited the outlook for US growth and has become more bullish or less pessimistic about US growth. We had another major announcement today that took recession out of their projections, the Bank of America. And then the second issue is I think people are starting to look at the inflation over the medium term, and they're starting to realize that it's going to be really hard to maintain a 2% inflation average over the medium term. That there are fundamental changes going on on the supply side that make it more likely that inflation will be higher than 2%.
- Mohamed, speaking of your tweets, there was another tweet where you talked about looking at different variables to assess the impact of this and why this was even necessary from bond yields to let's talk specifically about the dollar. Yes, not much movement there, but you also have some support from some economic news out today with regard to the dollar that's supportive there. But what does this do to the dollar, to you in your mind from your perspective for its status as the global reserve currency?
MOHAMED EL-ERIAN: Yeah, and that's the political side. So the economic and the market side, I think, is clear. Then there's the political side domestically and internationally. Domestically, this is likely to fuel more of the polarized conversations that are going on. Internationally for the adversaries of the US, they will point to that as yet another development in terms of the US no longer being as powerful and as influential. I think that those arguments are weak, but they will be used by that.
I think it's interesting that the dollar, the DXY index today is stronger rather than weaker. If people were taking this Fitch downgrade as a serious signal, we would expect the DXY index to be weaker. In fact, it's back up above one or two as you know.
- Earlier in the show, we were sort of combining the Fitch downgrade with the latest former President Trump indictment again as the signs of cultural and political dissent in the US. As we head towards another election, how much do investors need to pay attention to these issues?
MOHAMED EL-ERIAN: So you need to pay attention to geopolitical and political risk factors. But then you have to make an assessment as to, will they fundamentally influence the way the US economy behaves? One of the big advantages of the US economy relative to others is that the private sector is incredibly vibrant and tends to operate well under different governance developments.
If we start taking governance into account, then we are going to start worrying about a lot of countries, because the US is not the only one to have a polarized conversation going on. There's many other countries that are having difficulty forming governments, forming stable governments let alone controlling their narratives.
- Mohamed, besides governance, one of the things that Fitch cited in their decision was medium term fiscal challenges, namely the impact of the aging population on expenditure programs. So seeing over the next decade higher interest rates and the rising debt stock will increase the interest service burden due to an aging-- its aging population, rising health care costs, CBO projecting that these interest costs will double by 2033 to 3.6% of GDP. So given that kind of argument for it, just I guess playing devil's advocate with this question of why now? But does this matter more then down the line?
MOHAMED EL-ERIAN: So many of us have worried about the longer term fiscal outlook and the need critically to promote high, sustainable, inclusive growth. We don't have a debt problem as long as growth continues to pick up. And one of the upside surprises has been not only that actual growth has picked up, but the potential growth is starting to be positively impacted by the policy. And that's a really positive development that we haven't seen for a number of years.
So yes, we should focus on the longer term debt issue. The solution to that comes from economic growth and the need to revamp economic growth models. Most of the economic growth models in place today in the US, in Europe, in China are less potent and need to be revamped. And that's what I would focus on.
And ironically again, going back to the issue of timing, this comes after better than expected US growth numbers and after people have revised up the outlook for economic growth.
- So let's turn to your outlook for economic growth, Mohamed. Are you in agreement here that things are fairly solid at the moment? But not only that, that we could indeed have a soft landing and avoid a recession? What's your current thinking on that?
MOHAMED EL-ERIAN: So I've been consistent over the last year saying there is no reason for the US to fall into recession. If you look at the US economy on a standalone basis endogenously, it is vibrant enough, it is flexible enough, and it's handling this global soft patch well.
Is there a risk? Yes, there is but it comes from another policy mistake. My greatest worry is that the Fed will over-tighten. That the Fed will continue pursuing an inflation target, 2%, that makes less sense for today's structural and supply side elements.
If we were to sit down and try to formulate what is the ideal inflation target for the US economy? I doubt that we would come up with 2%. We'd come up with something closer to 3%. It acknowledges the change in globalization, it acknowledges the state of our labor market, it acknowledges the changes in supply chains, and critically, it acknowledges the energy transition.
The problem, as you know, is that it's very difficult for a central bank that has been missing its inflation target to announce a change in its inflation target. So I understand why the Fed doesn't want to talk about this. But the only reason we would fall into recession absent some massive geopolitical shock, the only reason we would fall into a recession is if the Fed is so focused on 2% and wants to deliver it quickly that it over tightens.
- As you say, Mohamed, this has been your concern for quite some time. We've been talking about it for a while. The Fed has been tightening all year. The economy's going OK. So what now does that policy mistake look like exactly? In other words, is another increase a policy mistake at its next meeting? Would it have to be further than that? Give us some sort of details around what that would look like.
MOHAMED EL-ERIAN: So first, as you know, I wouldn't have hiked in July, and I certainly wouldn't hike in September. But then there's a more fundamental issue, which is what I regard as excessive data dependency by the Fed. Yes, you want to look at the data, but you don't want to be driven by backward looking data when your tool acts with long and variable lags. So you have to have a strategic view of the economy as to where it's going and where is it likely to settle down on that.
So I would critically start moving away from this excessive data dependence. Because my biggest fear, Julie, is by the end of the year, headline inflation will start turning up again. And at that point, the Fed, if it continues to be excessively data-dependent will be put in a really hard position. And we don't want that. We want the Fed to take the long view to target the medium-term inflation and make sure that we don't unnecessarily damage economic growth in response to short-term data.
- Mohamed, I want to ask you about the potential impact, longer term impact, I suppose, to treasuries given the Fitch move. Does this create any kind of destruction of demand to say long-term treasuries or short-term treasuries?
MOHAMED EL-ERIAN: Not by itself. Diane, one of the big questions is what do you replace to US Treasury bonds with? A critical aspect as you know in financial markets is they often solve in relative, not absolute space. People have to hold something. And often, people are very tempted to say, this is no longer any good. And then you say, well, what is it being replaced by?
You cannot replace something with nothing. And so far, there is no single other country that can replace the US in terms of reserve currency and in terms of the most liquid financial system. So I don't think that this Fitch rating changes anything. Because if you were to apply the same criteria to other countries, you would probably downgrade them as well. And Fitch is going to have an issue now that it has put governance up front when asked well, what about these countries that can't form governments? What are you going to do with them?
- That is a great point, Mohamed. Finally, to end it on a light note as we like to do, just like there's no replacement for treasuries, there's no replacement for the Jets in your heart as we know. And full disclosure, full transparency, I am not a big football fan myself, but people on this team want to know if you think Aaron Rodgers is going to help the Jets win this year.
MOHAMED EL-ERIAN: If we have a good offensive line, he can help us break what has been a terrible record for quite a while now. But that's a big if. You know me, Julie, I'm going to start like every other Jet fan with irrational hope only to have it replaced by crushing disappointment. That is what happens to us Jets fan. The fact that we remain loyal is a puzzle to many people.
- Well, it's admirable. I think Jane, are you a Jets fan too?
- I switched to the Giants, Mohamed. It'll be better for you, I'm sorry. Yes, I'm sorry, listen, they're both here. Come on, switch. Just come on over.
MOHAMED EL-ERIAN: I've been suffering since 1969 so--
- Long suffering.
- It's part of it. It's why--
MOHAMED EL-ERIAN: I will allow you back in, back on the bandwagon.
- Be a bandwagon fan, it's fine.
- Definitely.
- There's free agents in the league, come on over.
- All right, Mohamed El-Erian, lifetime Jets fan. I don't think there's any change. Now, that's why when they win, it's so sweet. Allianz chief economic advisor and president of Queens College Cambridge. Thank you. Great to see you Mohamed.
MOHAMED EL-ERIAN: Thank you.