A 'trilemma' of problems has cornered the Fed again — but this time there's no good way out, Mohamed El-Erian says
The Federal Reserve is once again having to resolve a complex set of problems, according to Mohamed El-Erian.
'It's a trilemma — inflation, growth and financial stability," the top economist told CNBC.
But there's no "first best policy response" the Fed can take amid the banking turmoil, he said.
The Federal Reserve is once again juggling a complicated "trilemma" of problems — but this time, there's no good policy move it can make in the fallout from banking turmoil, Mohamed El-Erian has warned.
"It's not just a dilemma of inflation versus growth, it's a trilemma — inflation, growth and financial stability. And we don't have a good way out of it," the top economist told CNBC on Monday.
"The truth is there is no first best policy response any more. Everything would have collateral damage and unintended consequences," he said.
El-Erian thinks the best action the central bank could take right now is to ease up on its agressive campaign of interest rate hikes, which have taken rates from near zero to north of 4.75% in the past year. That's to make sure any lasting effects from the recent banking turmoil are long gone.
The banking industry has seen a string of shocking bank failures this month — from Silicon Valley Bank, Signature and Silvergate Capital in the US, to Credit Suisse in Europe. The rising borrowing costs have dented the valuations of financial assets like bonds, stocks and crypto — gravely hurt the valuations of SVB's assets in particular.
Worries have grown that the problems at SVB could spread to other lenders also exposed to the fast rise in interest rates. To help ease nerves, the Fed set up a new facility — the Bank Term Funding Program — to provide support for those under stress.
"I suspect the least bad is a pause after the hikes we've seen. Make sure that the financial contagion is behind us and then try to assess the economic contagion, which is harder to counter with policy," said El-Erian, who is chief economic adviser at Allianz.
"That is the most important question right now — the degree of economic contagion resulting from this mishandled interest rate cycle."
"Look, it is going to be significant, because of two different drivers here: 1. is banks themselves getting more conservative, but 2. is banks expecting regulation to get tighter."
Customers have pulled around $1 trillion in deposits from smaller banks since the Fed started raising rates, according to JPMorgan. About half of that has flown out since SVB foundered two weeks ago, as they rush to protect their money.
As pools of deposits dry up, banks are likely to turn more cautious about making loans — and that could lead to a credit crunch where small businesses and households find it harder to borrow. That then puts the US economy at risk of recession.
At the same time, the Fed is looking into what led to the collapse of SVB — and that could mean more stringent rules about their balance sheets in future, also feeding into a shift in activity.
"So far, what we've seen play out is duration mismatches. And when you have a loss of trust, and the deposit side flees, there's nothing you can do about your duration mismatch," El-Erian said.
"The problem we've got to be careful about is the credit side — the loan book — is this notion of rolling credit contractions that we're all worried about," he added.
The economist said he believes the Fed can sort out the interest rate mismatches that have squeezed companies.
"I'm more worried about the credit issues — and that really comes back to how badly hampered is the economy because of this mishandled interest rate cycle," he said.
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