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El-Erian: Fed Hasn’t Won Post-QE War (Yet)

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The Federal Reserve laid out definite plans to move away from quantitative easing last week, and the stock markets kept marching along.

The Dow Jones Industrial Average, in fact, is set to end the year with its biggest percentage gain since 1996. If the index ends 2013 above 16,422.11, it will top its 25.32% gain of 2003, making it the Dow’s best year since 1996 (when it climbed 26.01%).

But don’t crack open any champagne for a longer-term uptick in the markets, says Mohamed El-Erian, CEO and co-CIO of PIMCO.

“Central bankers have good reason to be more cautious about declaring victory at this stage. And the rest of us would be well advised to ask why,” he declared in an opinion piece in the Financial Times on Thursday.

Quantitative easing, El-Erian points out, “is widely believed to have significantly bolstered asset prices and, to a lesser extent, helped the real economy too.” And central bankers have made it clear that “policy interest rates would remain floored for quite a while.”

In fact, they’ve signaled that cuts to interest paid by the Fed to banks on excess reserves might be trimmed if needed. So why be cautious?

One, Fed policy is “overly dependent on using artificially high asset prices to alter household and company economic behavior,” according to the PIMCO executive.

It could be using other avenues, such as the credit channel and movement of cash into real economic investments. Concerns should continue “until the Fed witnesses improving economic fundamentals that validate artificially-elevated asset prices,” he points out.

Indeed, economist George Perry of the Brookings Institute said as much earlier this week in an article on his outlook for 2014. In that piece, Perry pointed out that the so-called wealth effects or impact from the rising stock market and strengthening home prices were “not reliable predictors of consumption.”

Disposable income, “which is more reliably linked to spending,” Perry says, “has not been rising much. A big improvement in consumer confidence … could provide a boost to spending. But there is little basis for building that into a forecast at this time.”

The second issue on El-Erian’s mind is that we are moving into more uncertainty around Fed policy, since the group is moving away from monthly purchases, a direct policy measure, towards the use of forward policy signals to influence behavior, an indirect measure.

“Issues regarding the degree of effectiveness and control could well come to the fore,” explained El-Erian. “Just witness the recent sharp upward moves in the 5-year U.S. Treasury yields, along with other intermediate maturities.” Third, the market’s strong technical indicators risk too much exuberance in the form of “price overshoots.” If the market turns around, current positive conditions could be disrupted through a decline in asset prices.

Fourth, there are have been central banks other the Fed that have been active in “maintaining economic and financial tranquility,” which have led to higher asset prices through imperfect policy instruments. And their challenges remain serious.

“The European Central Bank and the Bank of Japan are in the same boat [as the Fed,] explains the economist. “And they, too, face tricky policy issues ahead, with success also ultimately dependent on the overall ability of their economies to overcome the trio of inadequate aggregate demand, insufficient supply responsiveness and residual debt overhangs.”

Thus, the movement away from quantitative easing may have begun smoothly, but there’s no guarantee is will remain so in the long term. In other words, El-Erian concludes, the Fed has “yet to win the war.”

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