El-Erian: Investors Expect More 'Collateral Damage' From Fed Moves

Further, recent turmoil implies markets see the Fed struggling to catch up with investor expectations and what it needs to do to contain inflationary pressures, he said.

“Markets see a central bank that expects to cause more collateral damage as it tries to meet its inflation target,” El-Erian wrote, noting that Fed Chairman Jerome Powell recently indicated lower confidence in the likelihood of a “soft landing” for the U.S. economy as the Fed pursues higher interest rates.

“Powell has now repeatedly signaled more ‘pain’ ahead, implying an uncomfortably high probability of recession,” the economist added. ”The market appears to agree with this outlook.”

Market signals, notably the inverted yield curve on two-year and 10-year U.S. Treasury bonds, indicate the economy “lacks both a monetary-policy anchor and a sufficiently credible central bank,” El-Erian wrote.

The U.S. therefore needs more monetary tightening than it would have if the Fed had reacted to inflation “in a timely and credible fashion,” which will produce pain in foregone growth and in higher unemployment, “which will hit the most vulnerable segments of society the hardest,” he said.

The Fed, facing criticism that it’s pushing the economy into a recession, driving instability and wrecking wealth, may be tempted to forgo further rate hikes, but that could bring problems as well, El-Erian said. The bank instead should contain the consequences of its policy error by engaging in innovative thinking about its policy framework and collaborating more with other policymakers, he said.

“Sadly, it is too late to avoid all the detrimental economic and social consequences of the damage the Fed has caused to its own credibility,” he concluded. ”The central bank was notably late with its response to inflation. But it is not too late to contain the harm. Doing so is crucial.”