Federal Reserve 'Terrified' of Deflation: El-Erian

The Federal Reserve will announce a new round of easing next week because it is “terrified” of deflation, said Mohamed El-Erian, chief executive officer of Pimco.

But he doesn't believe a restart of the Fed's "quantitative easing" program at its Nov. 2 and 3 meeting will be very effective in delivering high growth or low unemployment. Quantitative easing is a term used to refer to the Federal Reserve injecting more money into the economy.

"QE is meant to drive down the price of safe assets so much that we are all pushed into doing something risky," El-Erian said in an interview Monday at a gathering of the Financial Women’s Association of New York.

Since the Fed first hinted at a new quantitative easing program in August, the dollar has weakened and risk assets, like stocks and commodities, have raced higher. El-Erian did not make a specific forecast on the amount of Treasurys the Fed would purchase, but he did say he will be looking for some "constructive ambiguity" in the Fed's statement, which would give it options.

El-Erian said the auction Monday of 5-year Treasury Inflation Protected Securities (TIPS) at a yield of -0.55 percent shows the economy is not gaining traction.

“I think it’s an indication that the unthinkable and the improbable, or at least what used to be unthinkable and what used to be improbable, is not only possible but is the reality,” he said.

El-Erian also said policy makers have done a very good job winning the war against a second depression, but pointed out that in every war, securing the peace is complicated.

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So what would he do if he could design a policy response? El-Erian said he would offer a plan that would include structural reforms to make the United States more competitive and the economy more flexible. He also said the U.S. needs a better social safety net and “a bit of QE.”

El-Erian does not believe QE on its own will help very much, and that with QE alone, the same issues will persist in six to nine months, while the rest of the world will be inflated. But he points out that the market has priced in additional asset purchases, so there is a high risk of disappointing investors if the Fed does not act.

As far asthe upcoming elections, El-Erian told CNBC that he worries about gridlock.

“Anybody who expects gridlock to be good doesn't understand that we need to achieve escape velocity. We need to go fast enough to start overcoming the debt overhang and we’re not gonna do that unless some pretty hard decisions are taken,” he said.

Globally, El-Erian reiterated that he personally believes Greece will need to restructure its debt within three years “because the alternative is much worse.”

But he said Greece is luckier than Argentina, because it is “in a better neighborhood,” and its rich neighbors will likely help mitigate some of its problems.

If Greece does default, the impact will be containable, El-Erian, a former IMF official, noted.

El-Erian also explained PIMCO’s significant reduction in a key fund's gold position from 10 percent to 3 percent. He said investing the precious metal “doesn’t make as much sense as it used to.” Because the price has moved so much and the trade is so crowded, he sees potential for a large technical retracement.

—CNBC Anchor Michelle Caruso-Cabrera contributed to this report.