PIMCO’s El-Erian Sees Tiny Taper at Fed Meeting, Yellen as Frontrunner

PIMCO’s Mohamed El-Erian says that he expects a drop — or taper — of about $10 billion to $15 billion in the level of the government’s monthly asset purchases when the Federal Open Market Committee meets Tuesday and Wednesday.

The Fed’s current leader, Ben Bernanke, is expected to step down in January, when his second term as chairman expires. A top candidate for the job, Larry Summers, withdrew his name for the post on Sunday amid growing opposition among Democrats.

“Suddenly, Janet Yellen has regained her status as frontrunner; that signals to the market more policy continuity, which the market takes well,” El-Erian (left), PIMCO CEO and co-CIO, said on CNBC early Monday. “The yield curve gets anchored, you get a bull steepener, the front end does well, repression of volatility, the equity market, the credit market like that, and [what] you get is a broad-based rally, and that’s what we’re getting this morning.”

(Other names batted around, observers say, include former Fed Vice Chairman Donald Kohn and former Treasury Secretary Timothy Geithner.)

Investors may enjoy the Yellen rally, but whoever is ultimately chosen for the post “won’t have as much room for maneuver as people expect,” El-Erian noted.

Over the next 12 months, the market expert predicts three things to happen at the Fed with respect to quantitative easing.

“First, they will taper. They’ll taper small to begin with, but they will taper,” he said, coming down from the current $85 billion-a-month bond-buying level.

Second, the Fed is “likely to favor the mortgage market, which means they’ll taper more with Treasuries in proportional terms,” El-Erian noted.

Third, he believes, the Fed will give itself “quite a bit of wiggle room” due to future uncertainly. In addition, it will “strengthen the forward guidance in order to minimize the impact on markets of the taper.”

Once this process is over, the PIMCO executive said, “I don’t think you’re going to see an increase in interest rates, because the economy remains weak. We’re nowhere near escape velocity.”

This week’s expected taper is not related to any declared “victory on the economy,” El-Erian says. “It’s because they’re worried about what Mr. Bernanke has called the costs and risks, the collateral damage, if you like, of using such a blunt instrument to impact markets.

Future Focus

While the Fed succeeded in “buying time for the system,” El-Erian explains, its approach has become increasingly ineffective: “You cannot repress interest rates forever in a modern market system without causing damage, and I think the Fed realizes that. That’s why it’s likely to engage on the taper.”

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Bernanke’s replacement will have to wrestle with the question of rising interest rates and related matters in the medium term, experts say.

Sen. Sherrod Brown, D-Ohio, began circulating a letter in late July calling on President Barack Obama to appoint Yellen. It was signed by 20 Senate Democrats. More than half of the Democratic women in the U.S. House signed a separate letter requesting Yellen’s nomination.

On Sunday, a group of more than 450 economists sent a letter to Obama supporting Yellen in a campaign organized by the Institute for Women’s Policy Research. The list included Robert Shiller of Yale, Alan Blinder of Princeton, Lawrence Kotlikoff of Boston University, Alice Rivlin of Brookings, Christina and David Romer of UC Berkeley, and Joseph Stiglitz of Columbia.

A week ago, it was reported that Lael Brainard, under secretary for international affairs at the Treasury Department, is under consideration for a vacancy at the Federal Reserve.

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