Pimco: Tricky for Fed to fix economy bind

By Jennifer Ablan and John Parry

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.