Mohamed El-Erian on AI Rally, Inflation, Central Bank Mistakes

Summary

The transcript covers several topics - the recent strong performance of AI/tech stocks, the outlook for US economic growth and productivity, the path of Fed policy and market expectations, and risks around inflation. Speakers discuss the transformational potential of innovations in AI/tech and life sciences to boost productivity. They also examine resilient US growth versus weakness abroad. On policy, speakers debate the appropriate pace of Fed rate cuts, the Fed's data-dependent approach, whether policy is restrictive enough, and risks of overtightening. There is acknowledgment of bumpy inflation data ahead that could sway Fed policy and challenge market expectations.

Takeaways

• 😊 Mohamed sees a computing/data/talent revolution ongoing that will grow in importance and have huge productivity impacts
• 😮 The sector can attract lots of investment and benefit other sectors too
• 🚀 It's a secular growth story with some excesses possible but real transformation occurring
• 🤔 Productivity gains could change how high rates need to go in coming years
• 😠 The Fed has been overly data dependent and reactive
• 🤨 Communication alignment between Fed and markets is important to maintain
• 🎉 US growth has offset recessions abroad allowing all boats to rise
• 🤔 Mobamed would target a higher inflation rate closer to 3% now if he were a central banker
• 😕 Biggest risk is Fed stays too tight for too long and doesn't cut rates by June
• 👍 There is evidence rates have slowed key sectors, but inflation may bump up and down

Q & A

What does Mohammed think about the market's reaction to the recent earnings report?

Mohammed thinks the reaction is understandable given the revolution going on in AI and related technologies that are growing in importance like computing power, data, talent and financing. He sees a long growth runway in this sector.

What is Mohammed's view on whether there will be excesses in parts of the market?

Mohammed acknowledges there will likely be excesses in parts of the market, but he believes there is a real secular growth story happening with AI and related technologies that can drive productivity gains and have a huge impact.

What is Mohammed's probability breakdown for future economic scenarios?

Mohammed assigns a 55% probability that inflation can be brought to a stable and low enough level without crushing the economy. He sees a 30% chance of a mild recession, and a 15% chance of rapid productivity gains leading to robust growth and moderate inflation (a "no landing" scenario).

Why does Mohammed think the Fed has been overly reactive?

Mohammed believes the Fed has been too data obsessed and reactive. He thinks they need to look further ahead rather than basing policy solely on recent monthly data prints, which means they end up constantly adjusting based on backward-looking data.

What evidence does Mohammed see that Fed policy has already had an impact?

Mohammed points to higher borrowing costs, major adjustments in interest rate sensitive sectors, and declining inflation as evidence that Fed tightening has already had an economic impact.

What does Mohammed see as the biggest risk from the Fed now?

Mohammed is most concerned the Fed will end up holding policy too tight for too long because they are surprised by bumpy inflation data. He thinks this could lead them to make the opposite mistake compared to 2021, when policy was too loose.

Why does Mohammed think foreign stock markets have rallied along with the US?

Mohammed believes investors are attracted to cheaper valuations abroad compared to the high US equity valuations. So there are spillovers occurring as global investors search for opportunities.

Should central banks be concerned about easing financial conditions?

Mohammed thinks they should not be concerned if they take a patient approach to getting inflation back down to 2% over an extended timeframe, perhaps aiming for something closer to 3%. But if they feel rushed to hit the 2% target quickly, then easy conditions would be worrying.

What lessons were learned last year regarding getting inflation down?

The lesson was that the Fed may be able to guide inflation back down towards target without needing to severely slow economic growth as initially feared.

Why was Mohammed confident in calling for rate cuts starting in June?

Because Mohammed is looking farther ahead at trends beyond just recent data. He believes firmly in the need for patience and doesn't think cuts in June are premature given his broader outlook.

Outlines

00:00

😊 Mohamed and John discuss AI stock volatility

Mohamed and John discuss the recent stock price volatility of AI/tech companies after earnings reports. They agree there is a revolution happening in AI/tech that will grow in importance. Mohamed says there will be excesses but the sector has a long runway for capabilities and demand.

05:02

😃 Explaining all-time highs in foreign markets

John asks how US strength explains all-time highs in Germany and Japan amid recessions. Mohamed says investors are looking at cheaper valuations abroad relative to the US. Strong US growth offsets weakness abroad.

10:03

😅 Mohamed believes Fed should aim for higher inflation target

Mohamed says if he were a central banker today, he would aim for an inflation target higher than 2% given supply-side issues. He would not rush to get inflation to 2%. This mindset means he is not concerned about easing financial conditions.

Keywords

💡secular story

A secular story refers to a long-term, structural trend that is driven by technological innovations or societal changes rather than short-term cyclical factors. In the video, Mohamed discusses the secular trends in AI, life sciences, and green energy that are transforming economies. These secular stories have very long runways for growth on both the supply and demand sides.

💡productivity

Productivity refers to economic output per unit of input (labor, capital, etc.). Mohamed and his guest discuss how the secular trends in AI and other technologies could significantly enhance productivity growth in the US economy over the long run. This would influence future Fed policy as higher productivity growth supports economic expansion without triggering excessive inflation.

💡data dependency

This refers to the Federal Reserve basing its monetary policy decisions predominantly on incoming economic data, rather than forecasts. Mohamed critiques the Fed's over-reliance on recent data, arguing they should take a forward-looking stance to policy to avoid lagging behind the economy.

💡inflation targeting

This refers to the numerical inflation rate goal set by central banks. Mohamed argues that in light of structural changes occurring in the economy, the Fed's 2% inflation target is too low, and should be raised to around 3%.

💡financial conditions

This refers to interest rates, credit availability, equity valuations and other factors influencing the ease of accessing financing in the economy. Mohamed discusses whether easing financial conditions should concern central banks struggling to reduce inflation.

💡disinflationary trends

Disinflation refers to the rate of inflation declining over time. Mohamed's guest discusses whether disinflationary trends emerging recently suggest the Fed can achieve its inflation target without severely slowing economic growth.

💡external shock

An external shock is an unpredictable event outside an economy that impacts growth, such as a natural disaster, geopolitical crisis, or spike in commodity prices. Mohamed warns these could tip the US into a mild recession, given risks the Fed policy stays too tight.

💡no landing scenario

This describes an ideal economic situation where high growth continues without triggering excessive inflation. Mohamed suggests there is a 15% chance productivity gains occur rapidly enough for the US to achieve this.

💡goods disinflation

Goods inflation refers to price increases for physical products. Mohamed's guest says the Fed wants to see goods disinflation continue to feel comfortable cutting interest rates.

💡too tight for too long

This describes the risk of the Federal Reserve keeping monetary policy too restrictive for an extended period. Mohamed argues this policy mistake is more likely than premature rate cuts due to the Fed's reactive, data obsession.

Highlights

There is a revolution going on in AI driven by computing power, data, talent and financing.

This is a secular story being drawn out now. There will be excesses in the market, but there is something real happening.

When working out productivity and growth potential, you've got to factor in transformational technologies.

It will be hard for the Fed and markets to stick to only 3 rate cuts given bumpy inflation data.

The equity market rally despite higher rates shows monetary policy is less important due to secular trends.

Overseas markets look cheap relative to the US, so we see massive spillovers as investors go fishing.

I wouldn't rush getting inflation to 2% given supply side issues. My target would be closer to 3% now.

Productivity gains may happen quicker than expected, leading to robust growth with low inflation.

The Fed shouldn't be obsessed with recent data. That leads to reactive policy and communication problems.

If the Fed doesn't cut rates in June, they risk making the opposite mistake compared to 2021.

US growth has offset recessions abroad, but overseas markets also hit highs as they look cheap.

Higher rates have impacted interest rate sensitive sectors, showing some restrictive impact.

The risk is now that the Fed stays too tight for too long if inflation data stays bumpy.

There's a 55% chance inflation falls without crushing growth, 30% chance of recession.

Don't need to see more data to support June cuts. Must look beyond data obsession given lags.

Transcripts

Mohamed, What a week it's been. I just want your early response, your

initial reaction to the price action yesterday off the back of earnings on

one single name. I think Jon is totally understandable.

I think there is a revolution going on in I said by four things that will only

grow in importance, and that is computing power, data, talent and

financing. There's a very long runway both on the

supply side and on the demand side for this sector.

On the supply side, we're going to see capabilities improving, expanding on on

the demand side. It's not just about add ons that a lot

of companies are talking about today and trying to do.

It is about developing things that are native.

So when I look at this, I totally understand the excitement about the

sector and I totally understand how that sector can suck investment into many

other things. So it doesn't surprise me.

This is a secular story drawn now. Will there be excesses in parts of the

market? Of course there will be.

But but there is something real going on that can enhance productivity and have a

huge impact. Secondary market in a secular story.

Can we talk about the cyclical impact, Mohammed, who we're talking to again to

Nordvig of ex-ante data and he was making the connection between what would

happen to growth in America, to productivity in America, and how the

Federal Reserve might have to reconsider how high rates might have to be in the

years to come. Are you making that connection yet?

In years to come. Yes, John, But this is not a Fed that

has been basing policy on years to come. This is a Fed that's been been basing

policies on past data. It's been overly data dependent.

But he's right in the sense that when working out productivity and growth

potential, you've got to factor that in. It is a transformational and it's not

the only one, Jon, you know, for you've been hearing me three that say there's

three of them. There's what's happening to Janet.

If I does, what's happening to life sciences and there's what's happening to

green energy. And you've talked to my colleague

Michael Spence on these issues and you know how strongly he feels as well.

Spencer is fantastic. I want to talk about the recent Fed

communication we've had as well. Mohamed Governor Waller, what's the

rush? Do you share that opinion?

What is the rush? Do you remember when when you repeated

what I said a few months ago when you asked me what's going to happen?

I told you what? Let me tell you what should happen and

what. Let me tell you what will happen.

And I said at that time, three cuts starting in June.

And that was at a time when the market was seeing 6 to 7 cuts starting in

March. So we are now in a really good spot.

We are now at a point where the market has finally converged to what the Fed

has signaled. And it's really important to try and

maintain that alignment because there's so much else going on.

So I think it is right to say patience, but that communication shouldn't go too

far. What's going to be hard, John, is to

stick to the three cuts, both by the market and by the Fed at a time when the

inflation data is going to get much more bumpy.

Mohamed, what surprised me. I'll tell you what didn't surprise me.

That spread closing had to close. I'll tell you something else that didn't

surprise me how that spread closed was with you.

The market coming today towards the Federal Reserve.

It's what didn't happen as that spread close, that shocked me.

We've priced down all those cuts we had priced in since the end of October.

We've pushed out the timing. We've reduced the magnitude of interest

rate cuts this year. And yet still this equity markets

carried on rallying the two year gilts up 50 basis points in just something

like three weeks and change happened and still this equity market carried on

running. And if you'd asked me at the time,

whatever my views worth back then, if we were going to close that gap in that

fashion, if two year yields, we're going to reprice higher by let's say 50 basis

points in three weeks. I would have said stocks down, stocks

down, hard stocks are up. How do you explain that, Mohammed?

How important is monetary policy to equity market pricing given the dynamics

in NVIDIA, in AI, in big tech? You know, John, simply put, it's one of

three factors. Interests are at risk, of course, has

been a significant headwind. But you've had two very strong

tailwinds. One we just talked about, which is the

secular journey that we've embarked on, led by these incredible innovations.

And then the second significant tailwind is the strength of the economy.

You know, we were also surprised by a 3.3% growth rate in the fourth quarter.

We were also surprised by an almost 5% growth rate in the third quarter.

And the U.S. locomotive has been strong enough to

offset the numbers you showed in terms of recessions in Germany, U.K.

and Japan. Do you think that should lift all boats

abroad, though? And you mentioned the recessions in the

U.K., Germany and Japan. We've also got all time highs in Germany

and Japan. Can you explain that just by the US

alone? Well, what are you guys playing by is

people looking at valuations, differentials and seeing that other

markets look incredibly cheap relative to the US and wanting to go fishing

there as well. You know, a lot of people have been

saying, well, if I'm going to invest at the US at these levels, just look at how

much cheaper other markets are. So you're getting massive spillovers

because people are looking at relativities strong.

Do you think those easing financial conditions should be of concern to

certain central banks still grappling and lacking confidence of getting

inflation back down towards target? So you taking me to the question that,

you know, I don't really like discussing, which is what is the

appropriate target? We living in a world where, given

everything that's going on in the supply side,

we're talking about geopolitics, we're talking about companies rewiring their

supply chains. We're talking about what's happening in

the labor market. That when you look at all this, if I was

a central banker, I would be aiming at actually long journey back to 2%.

I wouldn't rush to get back to 2% because in the back of my mind, I would

believe, as I believe right now, that if I was to set an inflation target today,

it will be higher to 2%. It would be closer to 3%.

But of course, I can't change that because I've missed my target for so

long. So I in the back of my mind, I would not

be in a rush to force it back to 2%. And that's really important.

If that is my, my, my mindset, then I can live with these financial

conditions. If my mindset is I need to get to 2%

really quickly and that's the right inflation target, then I would be

concerned about financial conditions. Well, but we also have to acknowledge

why you said that all that time ago. The reason you said that is because you

believed initially that in order to get back to 2% and oversight, 18 months, two

years, we needed to crush the economy to do that.

The lesson of last year was that maybe we don't.

Perhaps What's the question now that you'd be asking with regards to that, do

you think we can achieve that inflation target without crushing the service side

of the economy, given the disinflationary trends that have emerged

over the previous six months? So let me give you my probabilities.

I think it's about 55% probability that we can that we can get towards a stable

inflation rate that's low enough. It won't be 2%, but that's low enough.

And that's stable enough that it anchors in inflation expectations without

crushing the economy. I'll give that a 55%.

I'd give a 30% probability that either because of an external shock.

And there's a lot going on in the world right now or a domestic political change

or a policy mistake from the Fed of staying too tight for too long.

15% that will slip into a mild recession.

Sorry, 30% will slip into recession. And 15% is that the productivity gains

that will occur over a number of years. Happen much more quickly.

And then we find out that we get to what some people call the no landing.

That growth stays incredibly robust while inflation stays well behaved.

Mohamed Governor Waller yesterday was talking about they want to see a couple

of months of inflation data to make sure that they are prepared for these cuts.

You're looking at, June, What needs to happen in terms of goods, disinflation

between now and June for you to be comfortable?

No, I'm comfortable now and I'm comfortable now because I look way

beyond. I think that data dependency doesn't

mean data obsession. It is very, very, very problematic if

you get obsessed by buy data because you need to look forward your measures, act

with a lag. As you know, I'm married.

So if you are totally basing policies on the last few months of data, you will

get it wrong. And that is why we have had such a

reactive Fed. That is why communication has been such

a problem. So I don't need to see two more months

of data to feel comfortable cutting three times starting in June because of

what I see ahead. But if this Fed remains obsessed with

being data dependent and seemingly solely data dependent, that they want to

see goods inflation staying well tamed while service inflation coming down,

that's what they need to see. Mohamed, let's just finish this segment

by asking a simple question. I know it's difficult to answer, but

what evidence is there that they are sufficiently restrictive?

Looking across the economic data we've had not over the last month, but over

the last 12. So borrowing costs have gone up.

True spreads haven't gone up like everybody expected.

But that has to do with the fact that credit risk has got has been supported

by economic growth. Inflation has come down and it's not

just a supply side issue. We've seen major adjustment in interest

rate sensitive sectors. So there is evidence that they've had an

impact through higher rates. John, My concern honestly, is that now

the market and the Fed surprised by the fact that the inflation numbers are

getting more bumpy, will end up being too tight for too long.

Okay, let's just go there again. Let me ask that question, Mohamed.

You think the biggest risk here is that they hold too long, not cut too soon?

Correct. If they don't cut in June, then you'll

hear me say, oh, no, we now making the opposite policy mistake that we made

back in 2021.