Economist Says Fed ‘Badly Misdiagnosed’ Inflation, Warns of ‘Stagflationary Swamp’ If Another Error Made

Mohamed El-Erian, chief economic adviser of Allianz, at FOX Studios in New York, on April 29, 2016. (Rob Kim/Getty Images)

The economist Mohamed El-Erian has criticized the Federal Reserve for how poorly it has dealt with inflation, and he warned about the United States slipping into stagflation if policymakers do not deal with the issue carefully.

Because of having “badly misdiagnosed” inflation last year, the Federal Reserve “significantly intensified” its policy response in the last few months, El-Erian wrote in an op-ed at Bloomberg on Oct. 24. In just six months, he noted, policymakers raised interest rates by 3 percentage points, which is the Fed’s “most front-loaded one in a long time.” Sharp appreciation in the value of the U.S. dollar and the cooling down of the housing market are some of the consequences of these actions, the economist pointed out.

Investors expect the Fed to maintain interest rates at elevated levels for some time, and financial markets are pricing in rate hikes of 1.75–2.0 percentage points for the current cycle, El-Erian notes.

“Having to play catch-up, the world’s most powerful central bank risks pushing the U.S. economy into recession, throwing millions of people out of work, worsening income inequality, undermining its independence, and causing economic fires around the globe,” he writes.

“Yet, also as worrisome is the possibility that an early ‘pivot’ in Fed policy would risk leaving the United States languishing in a stagflationary swamp.”

El-Erian criticized the Fed for using lagging data and outdated monetary policy framework in its decision-making process. The speed at which the Fed keeps raising the interest rates “significantly increases” the risks of financial instability.

In the first quarter of 2022, the Fed raised its benchmark interest rate by 25 basis points (bps). It then raised rates two times in the second quarter, by 50 bps and 75 bps. The third quarter has seen two consecutive 75 basis-point increases, with the rates pushed up to a range of 3.0–3.25 percent.

Mistakes of the Fed

During an interview with CBS this month, El-Erian pointed out that the Fed had made two mistakes that might “go down in the history books.”

The first is that the central bank mischaracterized inflation as “transitory,” as something temporary. The Fed’s second mistake was that when it did recognize inflation as a problem, it failed to act in a “meaningful way.”

Due to these two mistakes, the United States risks slipping into a “damaging recession” that could have been avoided, he said.

And he is not alone. Kristina Hooper, Invesco’s chief global market strategist, for example, has also strongly criticized the Fed’s interest-rate hikes.

“When you are raising rates in 75 basis-point increments and you’re not giving any time for it to process through and make its way through into the data, you’re playing a dangerous game,” Hooper said on a Bloomberg podcast.

“And the more you’re doing it, the more likelihood you create of having a recession—and a significant recession.”