Agreeing and Disagreeing with a US$2 Trillion Fund Manager

by Nigel Bolton-Shaw on October 12, 2012

Mohamed A. El-Erian writes that “Central Banks Can’t Inflate Market Prices Forever.” Who is he? “Mohamed El-Erian is the CEO and Co-CIO of PIMCO, which oversees nearly $1.8 trillion in assets and runs the Pimco Total Return Fund, the largest bond fund in the world.”

He makes a good point, but not in our humble view, for reasons stated. According to El-Erian, “Markets have deviated quite a bit from economic fundamentals … due to central bank activism. Over the last few months, central bankers have re-inflated the wedge that separates weak fundamentals from high market prices.”

El-Arian approves of this: “European Central Bank’s unlimited securities purchase program, robust asset markets are an integral part of policy attempts to counter tail risks and deliver economic growth and jobs.”

This is one way of looking at it, but another is that central banks ought to get out of the business of moving various financial markets up and down like a yo-yo.

The issue is not so much the immediate effects as the long-term consequences when it comes to central banking moves. They force us to play the “great game.” He virtually spells it out:

By artificially inflating asset prices above levels justified by sluggish fundamentals, these two central banks hope to calm market concerns, ignite animal spirits and trigger the wealth effect. And their actions are contagious.

Whether they like it or not — and many don’t — other central banks continue to be pulled into more accommodating monetary policy. Witness this week’s round of interest rate cuts in Brazil and Korea as an example.

These cuts did not happen because they constitute a first best policy. Rather, they seek to counter the collateral damage emanating from the unconventional policies pursued by Western central banks.

Yet … there is a limit to how far and how long prices can deviate from fundamentals. This is particularly the case when central banks, acting without the support of other government entities, do not have sufficiently-refined tools to secure good and sustainable economic outcomes.

Even though El-Arian agrees with the concept of central bank activism (which we do not), he is obviously conscious of the effects. He warns people that central bank stimulation of financial markets does not guarantee everlasting high prices.

And he warns that market participation must be accompanied by judicious diversification. “Central banks should be respected,” he writes, “And they can certainly counter air pockets, but not forever. Either fundamentals will improve or asset prices will fall.”

OK. On this we CAN agree.


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