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Fed's Deflation Terror to Spur Easing, Inflation, El-Erian Says

Federal Reserve Treasury purchases will likely spur global inflation while failing to lower U.S. unemployment, according to Mohamed A. El-Erian, chief executive officer at Pacific Investment Management Co.

Quantitative easing, the strategy of buying bonds to cut borrowing costs, won’t be enough to deliver high economic growth, he said yesterday at a reception in New York sponsored by the Financial Women’s Association. The record amount of U.S. debt is another problem for the economy, said El-Erian, who is also co-chief investment officer at Pimco, which runs the world’s biggest bond fund.

“One thing that the Fed cannot do is stand still, it is terrified of deflation,” El-Erian said. “QE on its own means we’ll have the same issues in six to nine months time with the rest of the world being inflated.”

U.S. yields show investors increased bets on inflation to the highest level since May. Kansas City Fed Bank President Thomas Hoenig said quantitative easing is a “dangerous gamble” that risks higher costs in the economy and another financial crisis. John Brynjolfsson, chief investment officer at Armored Wolf LLC hedge fund, called Fed purchases a “bazooka.”

The difference between yields on 10-year notes and Treasury Inflation Protected Securities, a gauge of trader expectations for consumer prices, widened to 2.18 percentage points, matching the most since May 19.

Photographer: Ramin Talaie/Bloomberg

Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. (PIMCO). Close

Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. (PIMCO).

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Photographer: Ramin Talaie/Bloomberg

Mohamed El-Erian, chief executive officer of Pacific Investment Management Co. (PIMCO).

QE Estimates

Fed Chairman Ben S. Bernanke next week is likely to preside over a decision to buy more assets to increase the rate of inflation and reduce the cost of borrowing in real terms, comments from policy makers over the past week indicate. The goal is to unlock consumer spending and jump-start an economy that’s growing too slowly to push unemployment lower.

Estimates for the ultimate size of the asset-purchase program range from $1 trillion at Bank of America-Merrill Lynch Global Research to $2 trillion at Goldman Sachs Group Inc., with economists at both firms agreeing the Fed will likely start by announcing $500 billion after the Nov. 2-3 meeting. The danger is that once the Fed kindles price increases, inflation will be difficult to control.

Inflation ‘Genie’

“By reducing real interest rates and trying to break the psychology of ‘Why spend today when I can buy goods cheaper tomorrow,’ they are hoping to drive growth that would be more commensurate with a pickup in employment,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. “The risk is a late 1970s type of scenario where the inflation genie gets out of the bottle.”

The Treasury sold $10 billion of five-year Treasury Inflation Protected Securities at a negative yield for the first time at a U.S. debt auction yesterday as investors bet the Fed will be successful in sparking inflation. The securities drew a yield of negative 0.55 percent.

“If I were to design the right policy response and implement it, it would be a package that would include structural reforms making us more competitive and the economy more flexible, more safety nets,” said El-Erian, who is based in Newport Beach, California.

Fed policy makers, who have already cut interest rates almost to zero and bought $1.7 trillion of securities, are discussing more purchases of Treasuries to flood markets with cheap money.

“From my perspective, it is a very dangerous gamble,” Hoenig said in a speech in Lawrence, Kansas. “We risk the next crisis four or five years from now. Central bankers need to think of the long term.” Hoenig has dissented from every Fed policy decision this year.

Commodity Prices

Rising costs for metals, food and oil show the Fed is avoiding deflation, Brynjolfsson, who is based in Aliso Viejo, California, said in an interview on Bloomberg Television. Deflation is a general drop in prices.

“Their second goal is to achieve their target of 2 percent inflation,” he said. “The bazooka they have of quantitative easing should convince market participants that if that’s what they want, that’s what they’re going to get.”

Fresh Treasury purchases will drive commodity prices even higher as much of the money added to the U.S. economy spreads to other nations, El-Erian said.

The UBS Bloomberg Constant Maturity Commodity Index was about 1 percent away from a two-year high.

Pimco said separately quantitative easing from the developed world may boost investment in faster-growing emerging nations of Asia, including China, potentially fueling inflation.

China is heading for a more moderate, sustainable pace of economic growth, Chia-Liang Lian, a Singapore-based fund manager at Pimco, said in a discussion on the company’s website.

Pimco’s $252 billion Total Return Fund handed investors a gain of about 12 percent in the past year, beating roughly three-quarters of its peers, according to data compiled by Bloomberg. Pimco, a unit of Munich-based insurer Allianz SE, managed $1.1 trillion of assets as of June 30.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net Wes Goodman in Singapore at wgoodman@bloomberg.net.

To contact the editors responsible for this story: Dave Liedtka at dliedtka@bloomberg.net Rocky Swift at rswift5@bloomberg.net.

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