Mohamed El-Erian — president of Queen’s College, Cambridge, and chief economic adviser at Allianz — was an early critic of the Federal Reserve’s hesitancy to raise interest rates in 2021. Now, with seven interest rate hikes and the Fed’s “transitory” inflation framing firmly in the rearview mirror, El-Erian spoke with “Marketplace” host Kai Ryssdal about the central bank’s path forward. The following is an edited transcript of their conversation. 

Kai Ryssdal: It has been — I checked my records here — it’s been a little bit more than a year since we had you on, a lot obviously has happened. Last time you were here, “transitory” was the big thing, now it’s “soft landing” and when’s the Fed gonna pivot? Let me, before we get into details, get your sense of where this economy is right now.

Mohamed El-Erian: This economy is slowing. This economy faces an uncomfortably high risk of recession next year and this economy is stuck with inflation that is too high and a Federal Reserve that’s playing catch-up.

Ryssdal: Let’s get to that catch-up part. What would we look like right now if Jay Powell and the Fed had followed the advice of you and others and started hiking interest rates sooner than we did?

El-Erian: Let me start by saying counterfactuals are inherently tricky. However, what do we know? We know that, had they not fallen into this cognitive trap of inflation being transitory, had they acted earlier, they could have hiked into a growing economy. And they could have avoided what is one of the most front-loaded hiking cycles in history.

Ryssdal: Explain that for the civilians in the audience, “front-loaded hiking cycles.”

El-Erian: So, normally, you increase interest rates gradually and in a very measured fashion, because you want to assess the impact on the economy. If you are late — and the Fed has been very late — you have no choice but to move really quickly. To make it specific, this Fed has increased interest rates by .75% four times in a row. That is a record that is almost unheard of, including during the ’70s and ’80s, when we had a much bigger inflation problem. And they did that because they were so late and had to play catch-up. The problem with moving so quickly is that you don’t have enough time to assess what the impact on the economy is.

Ryssdal: So, to that point, Jeanna Smialek who’s at The New York Times, as I’m sure you know [and] she’s one of our Friday regulars. She noticed a Goldman Sachs observation the other day pointing out that Goldman Sachs, saying the impact of Fed policy might be hitting — instead of that very famous “long and variable lag” that Milton Friedman talked about — might be hitting right now. What do you make of that?

El-Erian: It certainly has hit right now in the financial markets. It certainly has hit right now in the housing market. The problem is that, because the Fed waited for so long, the inflation challenge has shifted from the interest rate-sensitive sectors to sectors that are less interest rate-sensitive: services and wages. So yes, they are hitting, and yet the Fed is still behind the curve. 

Ryssdal: Well, so what do you think the Fed should do?

El-Erian: Well, at this point, they have no choice but to go after inflation. That is their mandate. Because they’re so late, there will be undue damage to the real economy — to employment, to livelihoods — that could have been avoided. Because they’re so late, they’ve lost credibility. And because of that, we risk more financial instability.

Ryssdal: Let’s talk about the Fed’s credibility for a second. How do they — can they — get it back?

El-Erian: They can. They have to start by owning their mistakes, which they haven’t done yet.

Ryssdal: Well, I mean, Jay Powell has said to me, “We blew it.” I mean, he didn’t use those words, because he’s Jay Powell, but he said it certainly would have been better had we moved sooner. And that was, you know, five months ago, whatever it was, six months ago.

El-Erian: That’s absolutely right. And he has also acknowledged that there’ll be pain, but what they haven’t done — which is what the European Central Bank has done, the Bank of England have done — is explained to us why their forecasts have been consistently wrong in the same direction, and until they do that, markets won’t fully follow their guidance.

Ryssdal: Do you think they just have? Like, I mean, is it as simple as bad forecasters and bad modeling among the 400 Ph.D. economists that they have?

El-Erian: So, I think they’ve ended up with four issues, and I think that’s undebatable. One is failures of analysis and being cognitively trapped by the wrong characterization of inflation. Two: failure of communication. Their communication has been inconsistent. Three: Failures of forecasts. The forecasting errors have been not only significant but in the same direction consistently. And then the fourth one is failures of action. Even when they recognized, at the end of November last year, that inflation was not transitory, they didn’t move fast enough.

Ryssdal: So to the future now, the Federal Reserve Jay Powell specifically talks about we have to get back to 2%. And you know, everybody acknowledges we’re not going to be there for a very long time. Do you think it’s realistic for the Fed to try to get back to 2%? Or should they just say, “You know what, we’re gonna have to live with 3½ or 4?”

El-Erian: So, there’re several aspects to that question. Can they get us back to 2%? Yes, they can, but it would be at a massive cost to the real economy — that’s not a great way to get to 2%. Second, if they were formulating the inflation target today, I doubt it will be 2%. I think most people agree it would be higher than that. And then third is even though there’s good reason to have a higher target, this Fed that has lost credibility cannot be seen to be increasing the inflation target at a time when it has failed to meet its inflation target for so long. So the best we can hope for is, by the middle of next year, we’ve gotten to stable inflation of about 3% to 4%. They keep on telling us that they’re gonna pursue 2% in the future, and society learns to live with a stable inflation rate that is not 2%. That is the new definition of a soft landing, now that we can’t avoid a recession, unfortunately.