Mohamed El-Erian
- By the end of the year, the Fed will choose between the economy and its inflation target, Mohamed El-Erian said.
- The central will decide if it can tolerate inflation at 3% or higher — above its 2% target.
- Or the Fed will choose to "crush" the economy to reach its long-standing goal, he told CNBC.
The Federal Reserve needs to make a critical decision at the end of the year that will determine whether the US economy crumbles, according to top economist Mohamed El-Erian.
In an interview with CNBC on Tuesday, the Allianz chief economic advisor pointed to the market's overly optimistic stance on inflation, despite a hotter-than-expected inflation report in August that showed consumer prices rose 3.7%.
But El-Erian warned inflation's decline will be "much more complicated," forecasting headline prices to accelerate another 60 to 70 basis points, while core inflation will also likely be "less behaved" than expected.
"The Fed at the end of the year is going to have a choice: You live with 3% or higher inflation, or your crush the economy," he said, adding that he hopes the Fed doesn't crush the economy.
The US can live with inflation above 2% as long as it's stable, El-Erian said and described the 2% goal as "completely arbitrary."
He expects the Fed to push out its timeline of reaching 2% inflation further and further into the future until it eventually transitions to a higher target.
In the meantime, the stock market will have to absorb the prospect that rates will stay higher for longer, he added.
"The market has assumed the Fed will cut rates early next year. I don't think that's going to happen," El-Erian said.
Markets are currently pricing in a 37.8% chance that interest rates could tread higher than their current level by June 2024, according to the CME FedWatch tool.
Meanwhile, the New York Fed has priced in a 61% chance the economy could tip into recession by August of next year.
Though central bankers are officially aiming to lower inflation to a 2% long-run target, doing so could spark a severe downturn for the US economy, El-Erian has previously warned.