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Central Banks Can't Inflate Market Prices Forever: El-Erian

Mohamed El-Erian | CEO & CO-CIO, PIMCO
Friday, 12 Oct 2012 | 10:16 AM ET
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Some argue that the recent lackluster performance of global stocks is evidence that markets are tenuously positioned on an air pocket.

We would put it differently. While markets have deviated quite a bit from economic fundamentals, this is 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.

Whether it is the Fed's open-ended QE3 and extended forward interest rate guidance, or the 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.

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.

(Read More: Bond Buying May Be Biggest Ever )

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.

That central banks are essentially "all in" is, in the short term, good news for all types of markets—especially when compared to the air pocket hypothesis. Yet, as I detailed in Thursday's Financial Times, investors should not get too carried away.

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.

(Read More: Could the Fed's QE Plan Spiral Out of Control? )

As argued in Thursday's column, investors' romance with the "central bank put" should not be unconditional or everlasting. Moreover, it needs to be accompanied by significant portfolio differentiation, responsive management of overall risk exposures, and positioning that also reflects more durable global themes.

Central banks should be respected. And they can certainly counter air pockets, but not forever.

(Read More: Marc Faber: If I Were Bernanke, I Would Resign )

Either fundamentals will improve or asset prices will fall. Which outcome we eventually see depends in large part on whether other government entities finally step up to their policy responsibilities.

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. His book, "When Markets Collide, " was a New York Times and Wall Street Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year and was named a book of the year by The Economist and one of the best business books of all time by the Independent (UK).

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