The Fed is buying $85 billion of bonds per month. It has also promised to keep its target for the federal funds rate near zero at least as long as unemployment remains above 6.5 percent and forecast inflation is not above 2.5 percent.
“You’re looking at a transition where the Fed will remain engaged but will alter its policy mix,” by gradually reducing its bond buying while strengthening its forward guidance on short-term interest rates, he said.
He said he expects the Fed to cut the 0.25 percent rate it pays commercial banks on excess reserves as part of that transition. While such a move wouldn’t have a “dramatic impact,” it would underscore the Fed’s commitment to keeping rates low, he said.
Mushrooming Reserves
Banks’ reserves have mushroomed as the Fed purchased securities from them in its bid to lower long-term interest rates. Banks currently have more than $2 trillion in extra cash at the Fed, according to data from the central bank.
Even as the economy improves next year, it won’t achieve “escape velocity,” according to El-Erian. The big missing ingredient is stepped-up capital spending by companies.
“We have yet to see business investment really pick up,” he said. “Companies still prefer to use their excess cash for financial engineering” such as buying back shares or boosting dividends.