Trouble with the Fed two decades in the making

In late July the Federal Reserve decided against lowering interest rates despite signals that the economy was cooling.

Their inaction heightened concerns Mohamed El-Erian, an economist and an investor, has had about the Fed and central bankers for nearly two decades.

In this show, El-Erian highlights the problems he recognised in the financial system back in 2007 and why they're still haunting decision making now.

El-Erian is the award-winning author of When Markets Collide. It won the FT Business Book of the Year in 2008. Go to ft.com/bookaward to find out all the latest news, including the 2024 longlist.

RUNNING ORDER:

01:31 - Part 1: When markets collide.

05:26 - Part 2: The shock. The mistake. The fallout.

08:41 - Part 3: the trouble with the fed.

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Episode Transcript

(00:00):
Welcometo the Investor Download, the podcast
about the themes driving markets andthe economy now and in the future.
I'm your host, David Brett.

(00:23):
In late July, the Federal Reserve decidedagainst lowering interest rates despite
signals that the economy was cooling.
Monetary policymakers have decided to keepthe central bank's key interest rate
unchanged at the current range of fiveand a quarter to five and a half %.
Market consensus is still predicting up tofive interest rate cuts

(00:43):
before January next year.
So is the Fed in danger of fallingbehind the curve once again.
I spoke with Mohamed El-Erian,an economist and an investor.
He's also an award-winning writer of WhenMarkets Collide, which won the FT
Business Book of the Year Award in 2008.
In the book, El-Erian analysed the reasonsbehind the catastrophic collapse of the

(01:06):
financial system and in a post-financialcrisis world, what the new
market realities would be.
In this show, we'll discuss some of thoserealities that we're living with right now
and how they're affecting thedecision making we're seeing today.
On Apple Podcasts,Spotify, or wherever you get your

(01:27):
podcasts, you're listeningto the Investor Download.
It was in 2007, amidst the rumblings ofwhat would turn into a global financial
crisis, that El-Erian beganwriting When Markets Collide.
I started in 2007.
I was worried that the financial systemwas decoupling completely from the

(01:50):
underlying economy, that we evenstopped calling it financial services.
It became finance, as if it wasthe next level of capitalism.
I saw countries compete to be thebiggest financial system in the world.
And if it was a multiple of theGDP, it didn't seem to matter.
Think of Iceland, Switzerland, Dubai.

(02:13):
I started getting really worried.
And the book was an attemptto try and play this through
and ask the question, what happensif we don't get a course correction?
Lehman Brothers is going bankrupt.
And financial markets from from Asia toEurope are doing their utmost to prevent
Monday from turning from dark to black.

(02:35):
We had the financial crisisin the summer in September when Lehman
Brothers went down,and this was an opportunity to
resize the financial system.
Lehman Brothers collapse stole theheadlines, but there
were many big casualties.
Policymakers acted to bail out banks, pumphuge amounts of money into the economy,
and slash interest rates, all tokeep the financial system afloat.

(02:58):
Public balance sheets startedsubstituting for private balance sheets.
We blew up the balance sheet of centralbanks to nine trillion, in the case of the
Federal Reserve, for example, from undertwo trillion, trying to maintain
this finance-based system.
While we tried to de-risk the bankingsystem, we didn't pay enough

(03:20):
attention to the non-banks.
What happened is that the risks in thesystem morphed and migrated to something
that was even less well regulated.
But while acting in good faith, they alsoserve to exaggerate a problem which
contributed to the crisis in the firstplace, and it's a reality
we're dealing with today.
Well, we're still living with the bigone, which is that the finance is too big.

(03:45):
That we've overreli on finance, and we'veunderinvested in the genuine drivers of
productivity and growth,infrastructure, people, innovations.
The problem, as El Erian sees it, is thatpolicymakers at the time believe the shock
to the financial system was temporary.

(04:06):
I remember the mantra coming out of thefinancial 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 thirdT, should be temporary.
There was this notion thatwhat the West had experienced was a

(04:29):
cyclical shock, not a structural shock.
And cyclical shocksare like elastic bands.
You stretch them, they go back there.
So the notion was, oh, all that policyneeds to do is stabilise the system,
and the system will reset.
There wasn't an understanding that thesystem itself was out of whack
and that you needed fundamental reforms.

(04:50):
And that is how we came to be stuck inwhat El-Erian and his colleagues call the
new normal, an era defined by low growththat is anything but durable,
sustainable, and inclusive.
And those misconceptions that plagueddecision making in the immediate aftermath
of the financial crisis are stillhaunting policymakers to this day.
We are repeating the same mistake.
We had a shock, and we immediatelyassumed it was going to go away.

(05:12):
The shock, the mistake, and the fallout,that's coming up after the break.
Get in touch with us by email atschroderspodcasts@schroders.
com, or visit our website, schroders.
com/theinvestordownload.
It was 2021.
Parts of the West had begun to reopenafter the COVID-induced lockdowns.

(05:36):
Bringing in at the stroke of midnight.
But the cheers emanating from Madrid'sPuerta 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 emergencyand the lifting of a nationwide curfew.
That was the shock.

(05:57):
The world was stillawash with cheap credit.
Central banks have kept monetary policyloose to ward off the threat of
a deep downturn for the economy.
Those that could afford it werespending their cash in large quantities.
But companies struggled to keep up withdemand, in part due to supply chains
that were crippled by COVID restrictions.
Really, the problem now is thatdemand is very, very strong.

(06:21):
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 sectorreopening, and so you're seeing prices
are moving back up off their lows there.
The Fed chair, Jay Powell, reiteratingthat inflation has increased notably in

(06:42):
recent months, but does remain transitory.
In his written testimony for his hearingtomorrow before the House coronavirus
committee, he made no mention of when theFed might hike rates or the earlier
forecast for lift-off from last week.
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.

(07:06):
By May, June, July, the companieswere warning that their costs were going
up in a significant manner, and that theyhad confidence they could pass on
the higher costs into higher prices,and they were confident that
these prices would stick.
Maybe it's about time, Brian Cheung, ourFed Correspondent, gets in the ear
of J Pal and says, You know what?

(07:27):
Start tracking food inflation a littlemore broadly, because that's what people
are paying for in the grocery store.
Nonetheless, 17 food companies of latethat have highlighted inflation, inflation
in agricultural products,inflation in freight.
And now a lot of these food companiesare starting to take action.
And I kept on saying, Listen to what thecompanies are telling you,
don't just take the easy way out, thelazy way out of saying this is transitory.

(07:52):
This will just disappear on its own.
Spoiler alert, it didn't.
And this was the fallout.
Their misreading of the situation led theFed to raise interest rates 12 times from
March 2022 to levels not seensince before the financial crisis.
I'm old.
I've never seen theFederal Reserve increase interest rates by

(08:13):
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 toinflation that interest rates had to go up
very high, very quickly.
Now, inflation has fallen.
Are central banks at risk of making thesame mistake again when
it comes to cutting rates.

(08:34):
That's coming up in thefinal part of the show.
Us inflation came in around 2.
9% in July, down from higher levels inprevious 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 ratein August, the Fed opted

(08:55):
not to at the end of July.
El-Erian fears the same issues thataffected the Fed's decision making when
raising rates could beproblematic on the way down.
I think the Fed in particularsuffers from three things.
One is groupthink.
Unlike the Bank of England's MonetaryPolicy Committee, there

(09:15):
are no outside members.
Just the same people meeting in the sameroom, and the incentive system
is always to find some agreement.
Groupthink can lead to poor or irrationaldecisions due to the pressure for
conformity and harmony, often suppressingdissenting viewpoints and leading
to a lack of creative thinking.

(09:36):
The second is a lackof cognitive diversity.
There isn't enough cognitive diversityin those institutions,
which means that when something happensthat 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.

(09:57):
The third is hubris.
Central banks have been,quote, the only game in town for a long
time, and they grew intothis state of hubris.
In other words, theybelieve their own hype.
These issues are still unresolved, soEl-Erian remains unconvinced they won't

(10:17):
make the same mistakes again as theyface challenges to normalise rates.
I think if you're a centralbank, you have three challenges.
One is normalise.
You've run monetary policywith flawed interest rates,
enormous injections of liquidity.
You then missed a major turn,and you had to tighten monetary policy

(10:41):
significantly, and now you'vegot to, quote, soft land.
There's a whole monetary policy element.
Normalising rates also needs to beachieved alongside maintaining financial
stability and protectingvulnerable institutions.
We have segments of our financialsystem that are extremely vulnerable.

(11:02):
Most of those segmentsare now outside the banks.
There's a very important needfor the regulators, the financial
regulators, to understand how thesenon-banks operate and also
understand the linkages.
Part of the underlying issue is therapidly changing payment system from
digital and contactless tocryptocurrencies and AI.

(11:24):
The payment system is actually changingquite quickly, and central
bank have to stay up with that.
They've got a big job, but they are nolonger responsible,
as they thought they had been for a longtime, for delivering the
big macroeconomic outcomes.
We've discovered that finance,whether it's private finance or public
finance, cannotdeliver durable productivity gains

(11:49):
that result inhigh 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.
To add to the complication, policymakersare dealing with issues right now that
will fundamentally affect the economy fordecades, perhaps even centuries to come.

(12:12):
I think of it as aset of factors that's shaking us from
above and a set of factorsthat's shaking us from below.
From above, these are factorsthat will change how we do things.
It's about artificial intelligence.
It's about life sciences.
It's about sustainable energy.

(12:32):
They don't impact just what you do,but they impact how you do it.
And that isa fundamental signal that all of us
should be more preparedto course-correct in how we do things.
We're being given tools,incredibly powerful tools that we need
because we have incredibly big problems.

(12:54):
Then you have a certainnumber of sectors from below
that are being shakenbecause they're not working well.
They typically have what theeconomies call externalities.
They typically have lots of spillovers.
Health care is one of them.
Defence is another one.

(13:14):
Food security is another one.
So what you have is a system right nowthat's being shaken,
and we're having to redefineall sorts of relationships on that.
That This is a strong signal, and it comeson top of, of course, a complete change in
paradigms, both in terms of how we thinkglobalisation is going.

(13:40):
It's no longer the ever-closerintegration of goods, people, and finance.
It's now fragmentation.
And domestically, I grew up in a simpleworld that had something called the
Washington Consensus, that most countriesagreed that
the path to prosperity is deregulation,liberalisation and financial prudence.

(14:02):
And today, we have industrial policy,we have tariffs, and we have
fiscal irresponsibility.
So these are fundamental changes to how wedo things that are going to impact
the system for a long time.
Whether the Fed and other central banksare able to stick the landing and maintain

(14:25):
financial stability,we'll find out in the coming months.
Just before you go, I should say that thispodcast was recorded in conjunction with
the Financial Times Business Book of theYear Awards, which is
partnered by Schroders.
Go to FT.com/bookaward to find out all thelatest news, including the 2024 longlist.

(14:45):
You can listen to my full unabridgedinterview with El-Erian on Schroders'
YouTube channel, where we talk more abouthis life, markets,
cryptocurrencies, and AI.
That was the show.
We very much hope you enjoyed it.
You can subscribe to the investordownload wherever you get your podcast.

(15:06):
And if you want to get in touch withus, it's schroderspodcast@schroders.
com.
And you can find out much,much more at schroders.
com/insights.
New shows drop every otherThursday at 05:00 PM UK time.
In the meantime, keep safe and go well.
The value of investments and the incomefrom them may go down as well as up, and

(15:28):
investors may not get back theamounts originally invested.
Past performance is not aguide to future performance.
The information is not an offer,solicitation, or recommendation of any
funds, services, or products, orto adopt any investment strategy.