Pimco: Tricky for Fed to fix economy bind

NEW YORK (Reuters) - Bond fund leader Pimco's Mohamed El-Erian on Wednesday said the Federal Reserve's monetary policy may not help the economy to escape a severe recession caused by falling home values and rapidly rising consumer prices.

The co-head of the world's largest bond fund company said U.S. policy-makers "do not have good policy tools to deal with the destabilizing combination of asset price deflation and goods inflation."

El-Erian added that the Fed is "particularly challenged" because of its dual mandate that calls for maintaining solid employment and low inflation.

"This comes at a time when regulators are trying to play catch-up with a financial system that has morphed into something that does not fit neatly into existing frameworks and mindsets," El-Erian wrote to clients after Pimco's quarterly economic forum at its Newport Beach, California headquarters.

On Wednesday, lawmakers listened to former Fed Chairman Paul Volcker discuss what role the U.S. central bank could now play.

"The Federal Reserve ought to be the principal financial regulator. Because of its independence, it is in a better position to resist the political pressures of regulation," former Volcker told lawmakers. But he warned that the central bank is not currently in a position to take on that role.

Policy-makers can, however, tackle inflation: Despite a tamer-than-expected U.S. April consumer price index released on Wednesday, many bond market participants are still concerned that rising food and energy-fueled inflation may push yields steeply higher and force the Fed to start hiking interest rates as soon as the end of this year.

"Inflationary pressures will continue to increase over the secular horizon," said El-Erian, who helps oversee $750 billion in assets. As commodity prices continue to rise because of higher demand accompanied by higher wages in emerging economies, "especially from the perspective of the U.S., look for inflation to become more sensitive to foreign factors," he wrote.

That is not only issue facing the U.S. economy.

The 10-month-old credit crisis, which has already forced banks to write off hundreds of billions of dollars for bad investments in riskier assets and recapitalize balance sheets, will now force households and consumers to scale back and save, he expects.

"The world has been going through a sequential secular recapitalization process," over more than a decade, he wrote.

This happened during the Asian, Russian and Latin American financial market crises between 1997 and 2002, in the United States with troubles at Enron and WorldCom in 2002-2003 acting as catalysts and now with banks.

"The U.S. household will inevitably be the next part of this process in the period ahead," he said, characterizing consumers as being overwhelmed by "debt exhaustion."

The major concern El-Erian has is that consumers have yet to recapitalize their balance sheet notwithstanding mounting pressure from sluggish employment, high energy and food prices, less ample access to credit and, most importantly, a housing price correction "that is still far from complete."

"The longer the delay out of Washington, D.C., in implementing fiscal measures to stabilize the housing sector, the greater the risk that the higher collateral damage on Main Street will induce a politically driven regulatory over-reaction with unpredictable economic outcomes," he added.

El-Erian also said the Fed's move to let securities firms borrow directly through its discount window will likely evolve into a permanent facility.

Investment banks, forced to unwind years of huge leverage, will seek ways to secure a deposit base that can reduce their cost of funding, including through merger and acquisition, El-Erian added. "This process of deleveraging and, if done properly, de-risking will have a number of implications for investors," El-Erian said.

"And by creating an initial vacuum in the more highly leveraged space vacated by investment banks, it will entice new entrants, some of which will come from the current generation of private equity and hedge funds."

Pimco's forum included its economic consultant, former Fed Chairman Alan Greenspan, as a participant.

(Reporting by Jennifer Ablan and John Parry; Editing by Jonathan Oatis)