Podcast: The problem facing the Fed two decades in the making
The Federal Reserve and other central banks face the dilemma over when and how to cut interest rates. But could their decision making be hindered by issues two decades in the making?
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The full transcript is available below:
[00:00:00.12] - Announcer
Welcome to the Investor Download, the podcast about the themes driving markets and the economy now and in the future.
[00:00:14.15] - David Brett
I'm your host, David Brett. In late July, the Federal Reserve decided against lowering interest rates despite signals that the economy was cooling.
[00:00:29.24] - News clip
Monetary policymakers have decided to keep the central bank's key interest rate unchanged at the current range of five and a quarter to five and a half %.
[00:00:40.03] - David Brett
Market consensus is still predicting up to five interest rate cuts before January next year. So is the Fed in danger of falling behind the curve once again. I spoke with Mohamed El-Erian, an economist and an investor. He's also an award-winning writer of When Markets Collide, which won the FT Business Book of the Year Award in 2008. In the book, El-Erian analysed the reasons behind the catastrophic collapse of the financial system and in a post-financial crisis world, what the new market realities would be. In this show, we'll discuss some of those realities that we're living with right now and how they're affecting the decision making we're seeing today.
[00:01:24.13] - Announcer
On Apple Podcasts, Spotify, or wherever you get your podcasts, you're listening to the Investor Download.
[00:01:31.21] - David Brett
It was in 2007, amidst the rumblings of what would turn into a global financial crisis, that El-Erian began writing When Markets Collide.
[00:01:41.05] - Mohamed El-Erian
I started in 2007. I was worried that the financial system was decoupling completely from the underlying economy, that we even stopped calling it financial services. It became finance, as if it was the next level of capitalism. I saw countries compete to be the biggest financial system in the world. And if it was a multiple of the GDP, it didn't seem to matter. Think of Iceland, Switzerland, Dubai. I started getting really worried. And the book was an attempt to try and play this through and ask the question, what happens if we don't get a course correction?
[00:02:26.01] - News clip
Lehman Brothers is going bankrupt. And financial markets from from Asia to Europe are doing their utmost to prevent Monday from turning from dark to black.
[00:02:35.24] - Mohamed El-Erian
We had the financial crisis in the summer in September when Lehman Brothers went down, and this was an opportunity to resize the financial system.
[00:02:45.05] - David Brett
Lehman Brothers collapse stole the headlines, but there were many big casualties. Policymakers acted to bail out banks, pump huge amounts of money into the economy, and slash interest rates, all to keep the financial system afloat.
[00:02:58.08] - Mohamed El-Erian
Public balance sheets started substituting for private balance sheets. We blew up the balance sheet of central banks to nine trillion, in the case of the Federal Reserve, for example, from under two trillion, trying to maintain this finance-based system. While we tried to de-risk the banking system, we didn't pay enough attention to the non-banks. What happened is that the risks in the system morphed and migrated to something that was even less well regulated.
[00:03:31.03] - David Brett
But while acting in good faith, they also serve to exaggerate a problem which contributed to the crisis in the first place, and it's a reality we're dealing with today.
[00:03:40.06] - Mohamed El-Erian
Well, we're still living with the big one, which is that the finance is too big. That we've overreli on finance, and we've underinvested in the genuine drivers of productivity and growth, infrastructure, people, innovations.
[00:03:58.15] - David Brett
The problem, as El Erian sees it, is that policymakers at the time believe the shock to the financial system was temporary.
[00:04:05.24] - Mohamed El-Erian
I remember the mantra coming out of the financial crisis, which was the three T's. Policy should be targeted. Everybody agrees on that. Should be timely. Everybody agrees on that. And there was the third T, should be temporary. There was this notion that what the West had experienced was a cyclical shock, not a structural shock. And cyclical shocks are like elastic bands. You stretch them, they go back there. So the notion was, oh, all that policy needs to do is stabilise the system, and the system will reset. There wasn't an understanding that the system itself was out of whack and that you needed fundamental reforms.
[00:04:50.09] - David Brett
And that is how we came to be stuck in what El-Erian and his colleagues call the new normal, an era defined by low growth that is anything but durable, sustainable, and inclusive. And those misconceptions that plagued decision making in the immediate aftermath of the financial crisis are still haunting policymakers to this day.
[00:05:07.18] - Mohamed El-Erian
We are repeating the same mistake. We had a shock, and we immediately assumed it was going to go away.
[00:05:12.22] - David Brett
The shock, the mistake, and the fallout, that's coming up after the break.
[00:05:17.23] - Announcer
Get in touch with us by email at schroderspodcasts@schroders.com, or visit our website, schroders.com/theinvestordownload.
[00:05:28.18] - David Brett
It was 2021. Parts of the West had begun to reopen after the COVID-induced lockdowns.
[00:05:36.03] - News clip
Bringing in at the stroke of midnight. But the cheers emanating from Madrid's Puerta de la Sol Square were not from a traditional New Year's gathering the Ring, but rather to celebrate the end of a six-month state of emergency and the lifting of a nationwide curfew.
[00:05:55.22] - David Brett
That was the shock. The world was still awash with cheap credit. Central banks have kept monetary policy loose to ward off the threat of a deep downturn for the economy. Those that could afford it were spending their cash in large quantities. But companies struggled to keep up with demand, in part due to supply chains that were crippled by COVID restrictions.
[00:06:16.05] - News clip
Really, the problem now is that demand is very, very strong. Incomes are high. People have money in the bank accounts. Demand for goods is extremely high, and it hasn't hasn't come down. We're seeing the service sector reopening, and so you're seeing prices are moving back up off their lows there.
[00:06:38.00] - News clip
The Fed chair, Jay Powell, reiterating that inflation has increased notably in recent months, but does remain transitory. In his written testimony for his hearing tomorrow before the House coronavirus committee, he made no mention of when the Fed might hike rates or the earlier forecast for lift-off from last week.
[00:06:55.08] - David Brett
And there it was, the mistake. During the financial crisis, policymakers used the word temporary. During COVID, that word was transitory, but inflation would prove anything but.
[00:07:06.11] - Mohamed El-Erian
By May, June, July, the companies were warning that their costs were going up in a significant manner, and that they had confidence they could pass on the higher costs into higher prices, and they were confident that these prices would stick.
[00:07:22.19] - News clip
Maybe it's about time, Brian Cheung, our Fed Correspondent, gets in the ear of J Pal and says, You know what? Start tracking food inflation a little more broadly, because that's what people are paying for in the grocery store. Nonetheless, 17 food companies of late that have highlighted inflation, inflation in agricultural products, inflation in freight. And now a lot of these food companies are starting to take action.
[00:07:42.23] - Mohamed El-Erian
And I kept on saying, Listen to what the companies are telling you, don't just take the easy way out, the lazy way out of saying this is transitory. This will just disappear on its own.
[00:07:55.05] - David Brett
Spoiler alert, it didn't. And this was the fallout. Their misreading of the situation led the Fed to raise interest rates 12 times from March 2022 to levels not seen since before the financial crisis.
[00:08:06.18] - Mohamed El-Erian
I'm old. I've never seen the Federal Reserve increase interest rates by 75 basis points, 0.75 percentage points, four times in a row. It was unthinkable. That's not what you do. But there was so late in responding to inflation that interest rates had to go up very high, very quickly.
[00:08:27.05] - David Brett
Now, inflation has fallen. Are central banks at risk of making the same mistake again when it comes to cutting rates. That's coming up in the final part of the show.
[00:08:40.03] - David Brett
Us inflation came in around 2.9% in July, down from higher levels in previous years, but still above the Federal Reserve's long-term target of 2%. The UK's inflation has fallen to 2.2%, but while the UK cut its interest rate in August, the Fed opted not to at the end of July. El-Erian fears the same issues that affected the Fed's decision making when raising rates could be problematic on the way down.
[00:09:05.19] - Mohamed El-Erian
I think the Fed in particular suffers from three things. One is groupthink. Unlike the Bank of England's Monetary Policy Committee, there are no outside members. Just the same people meeting in the same room, and the incentive system is always to find some agreement.
[00:09:26.17] - David Brett
Groupthink can lead to poor or irrational decisions due to the pressure for conformity and harmony, often suppressing dissenting viewpoints and leading to a lack of creative thinking.
[00:09:36.21] - Mohamed El-Erian
The second is a lack of cognitive diversity. There isn't enough cognitive diversity in those institutions, which means that when something happens that is out of the normal range of distribution of outcomes, people don't see it. They redefine it. They fall into all the behavioural traps.
[00:09:57.14] - David Brett
The third is hubris.
[00:10:00.03] - Mohamed El-Erian
Central banks have been, quote, the only game in town for a long time, and they grew into this state of hubris.
[00:10:10.15] - David Brett
In other words, they believe their own hype. These issues are still unresolved, so El-Erian remains unconvinced they won't make the same mistakes again as they face challenges to normalise rates.
[00:10:21.22] - Mohamed El-Erian
I think if you're a central bank, you have three challenges. One is normalise. You've run monetary policy with flawed interest rates, enormous injections of liquidity. You then missed a major turn, and you had to tighten monetary policy significantly, and now you've got to, quote, soft land. There's a whole monetary policy element.
[00:10:48.20] - David Brett
Normalising rates also needs to be achieved alongside maintaining financial stability and protecting vulnerable institutions.
[00:10:56.14] - Mohamed El-Erian
We have segments of our financial system that are extremely vulnerable. Most of those segments are now outside the banks. There's a very important need for the regulators, the financial regulators, to understand how these non-banks operate and also understand the linkages.
[00:11:16.24] - David Brett
Part of the underlying issue is the rapidly changing payment system from digital and contactless to cryptocurrencies and AI.
[00:11:24.13] - Mohamed El-Erian
The payment system is actually changing quite quickly, and central bank have to stay up with that. They've got a big job, but they are no longer responsible, as they thought they had been for a long time, for delivering the big macroeconomic outcomes. We've discovered that finance, whether it's private finance or public finance, cannot deliver durable productivity gains that result in high inclusive and sustainable growth. They can give you a sugar rush, but they cannot do the fundamental work needs to be done to improve productivity.
[00:12:03.02] - David Brett
To add to the complication, policymakers are dealing with issues right now that will fundamentally affect the economy for decades, perhaps even centuries to come.
[00:12:12.01] - Mohamed El-Erian
I think of it as a set of factors that's shaking us from above and a set of factors that's shaking us from below. From above, these are factors that will change how we do things. It's about artificial intelligence. It's about life sciences. It's about sustainable energy. They don't impact just what you do, but they impact how you do it. And that is a fundamental signal that all of us should be more prepared to course-correct in how we do things. We're being given tools, incredibly powerful tools that we need because we have incredibly big problems. Then you have a certain number of sectors from below that are being shaken because they're not working well. They typically have what the economies call externalities. They typically have lots of spillovers. Health care is one of them. Defence is another one. Food security is another one. So what you have is a system right now that's being shaken, and we're having to redefine all sorts of relationships on that. That This is a strong signal, and it comes on top of, of course, a complete change in paradigms, both in terms of how we think globalisation is going. It's no longer the ever-closer integration of goods, people, and finance.
[00:13:45.15] - Announcer
It's now fragmentation. And domestically, I grew up in a simple world that had something called the Washington Consensus, that most countries agreed that the path to prosperity is deregulation, liberalisation and financial prudence. And today, we have industrial policy, we have tariffs, and we have fiscal irresponsibility. So these are fundamental changes to how we do things that are going to impact the system for a long time.
[00:14:21.01] - David Brett
Whether the Fed and other central banks are able to stick the landing and maintain financial stability, we'll find out in the coming months.
[00:14:29.23] - David Brett
Just before you go, I should say that this podcast was recorded in conjunction with the Financial Times Business Book of the Year Awards, which is partnered by Schroders.
[00:14:39.21] - David Brett
Go to FT.com/bookaward to find out all the latest news, including the 2024 longlist. You can listen to my full unabridged interview with El-Erian on Schroders' YouTube channel, where we talk more about his life, markets, cryptocurrencies, and AI.
[00:14:59.11] - David Brett
That was the show. We very much hope you enjoyed it. You can subscribe to the investor download wherever you get your podcast. And if you want to get in touch with us, it's schroderspodcast@schroders.com. And you can find out much, much more at schroders.com/insights. New shows drop every other Thursday at 05:00 PM UK time. In the meantime, keep safe and go well.
[00:15:24.01] - Announcer
The value of investments and the income from them may go down as well as up, and investors may not get back the amounts originally invested. Past performance is not a guide to future performance. The information is not an offer, solicitation, or recommendation of any funds, services, or products, or to adopt any investment strategy.
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