Inflation has a 75% chance of rebounding or staying high, and the Fed could crush the economy in its attempt to fight it, Mohamed El-Erian says

• Inflation has a 75% chance of rebounding, according to top economist Mohamed El-Erian.
• Investors have been cheering a rally in stocks, but optimism around lower inflation may be premature.

Inflation has a 75% chance of rebounding, and the Fed could end up crushing the economy as it struggles to rein in soaring prices, according to top economist Mohamed El-Erian.

"Nearly two years into the current bout of inflation, the concept of 'transitory inflation' is making a comeback as the COVID-related supply shocks dissipate," El-Erian said in an op-ed for Project Syndicate on Thursday, referring t0 2021, when central bankers described inflation as "transitory". Prices would then skyrocket to a 41-year-high, forcing Fed officials to walk back their words and aggressively hike interest rates in 2022 to cool off the economy.

But recently, markets have grown more optimistic about inflation: prices eased to just 6.5% in December, and the Fed dialed back the size of its rate hikes to 25 basis-points in February, down from 50 at the previous meeting. Investors are now pricing in just a few more rate hikes before the central bank stops tightening its policy. The stock market has been rallying on the potential for a more dovish Fed so far in 2023.

But that optimism is premature, El-Erian warned, as inflation has a significant chance of rebounding or remaining elevated. He estimated that there was only a 25% chance of inflation steadily declining from here, and a 25% chance that prices would bounce back sharply, causing a "U inflation" scare.

He added the most likely scenario was inflation remaining sticky at 3%-4%, which El-Erian estimates has a 50% probability.

"This would force the Fed to choose between crushing the economy to get inflation down to its 2% target … or waiting to see whether the US can live with stable 3% to 4% inflation," he said, suggesting the Fed would need to keep interest rates high.

That could spell trouble for the economy and markets, as high interest rates weighed heavily on the market last year and could potentially overtighten the economy into a recession, experts warn.

Still, El-Erian has been adamant that the Fed faces bigger risks if they loosen up on inflation too early, which could cost the central bank its credibility and spark another 70s-style stagflation crisis if price expectations spiral out of control.

"If an inflation scare is temporary, the best way to deal with it is simply to wait it out (or, to use a policy and market term, 'look through it'). That is why this narrative is particularly dangerous. By encouraging complacency and inertia, it could exacerbate an already serious problem and make it harder to solve," he warned.

That mirrors the view of other bearish commentators, who warn that inflation may not be over just yet. UBS warned that inflation's recent downward trend could be an "inflation head-fake." Bank of America also warned of rebounding inflation, which could flip the stock market upside down, analysts said.