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- Recession odds are below 50%, but a Fed policy mistake could worsen them, Mohamed El-Erian told CNBC.
- If they keep rates longer than necessary, such as cutting after June, the chances of a recession rise.
- Tuesday's CPI data was a wake-up call for investors who have gotten carried away, he said.
Though economic strength has kept a US recession at bay, a downturn could still happen if the Federal Reserve's constrictive monetary policy stretches on for longer than necessary, economist Mohamed El-Erian told CNBC.
While a slowdown is guaranteed, the odds of a recession stand below 50%, he said. The economy has proven inherently strong, withstanding tough geopolitical and domestic circumstances.
At this point, only a disorderly financial adjustment or a central bank policy mistake could tip the balance, such as if the Fed hesitates to cut rates when the time comes.
"That is now the policy mistake, that [Fed officials] are so scared — because they were late, because they communicated poorly, because their forecasts are wrong — that they've been so shaken up, that they end up staying too tight for too long," the Queens' College president said.
January's inflation data did give the central bank reason to hold for longer, as Tuesday's report came in hotter than investors anticipated. Month-to-month core CPI grew 0.4%, compared to expectations of a 0.3% increase.
This update makes June an appropriate time for the first interest rate cut, but problems would manifest if the Fed were to hold out into September, for example, El-Erian said. Failure to come through with three cuts would also be a policy mistake.
Generally, the US economy is suffering a "stock problem," as the market's rally been built on excessive Fed cut expectations.
Instead, the CPI data provided a wake-up call for carried-away investors, El-Erian said, which explains Tuesday's market overreaction to the report. At one point, the Dow Jones shed over 700 points due to the high inflation reading.
"But the good news is that there's lots of money on the sidelines, waiting to engage at lower valuations. So we can manage through this as long as it is not too disorderly," he noted.