Deflation represents a genuine threat, though it isn’t the most likely scenario for the U.S. economy, says Pimco CEO Mohamed El-Erian.
He earlier this month said he sees a 25 percent chance of a double-dip recession.
Financial markets are pricing in several different factors, El-Erian tells Bloomberg.
“First, (economic) data have weakened across the board,” he said. “Second, there is a recognition by policymakers that the outlook is weak and unusually uncertain," he said.
“And third, there is fear that even a small increase in the probability of deflation, because it’s such a big outcome, can make a big difference in how much people want to self insure.”
Deflation is commonly defined as a decrease in the general price level of goods and services. Deflation occurs when the annual inflation rate falls below zero percent, resulting in an increase in the real value of money and allowing one to buy more goods with the same amount of money.
The Federal Reserve’s recent announcement that it will buy Treasuries shifts it from a tightening mode, in which it was shrinking its balance sheet, to a neutral mode where it’s maintaining the balance sheet, El-Erian explains.
“Most people hoped they’d do more — start easing by expanding the balance sheet.”
But we shouldn’t become overly dependent on the Fed, he says. “It doesn’t have enough instruments for what we’re looking at,” El-Erian argues.
“Structural problems require structural solutions. We’re not getting any.”
To deal with the uncertainty, Pimco has raised the quality of its bond holdings, El-Erian says.
Yale economist Robert Shiller also thinks the economy needs more than the Fed is offering.
"Beyond the Fed, I'd like to see the government take a renewed stimulus package focused on creating jobs and on activities that involve a lot of people," he told MarketWatch.
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