- Economist Mohamed El-Erian warned that the Fed's efforts to combat inflation could tip the economy into recession.
- Investors are watching the relationship between bond yields for clues on how close the U.S. is to contraction. So far, recession risks appear low.
- However, El-Erian said consumers are facing "a cost-of-living crisis."
The Federal Reserve's efforts to fight inflation threaten to sink the U.S. into contraction, according to economist Mohamed El-Erian.
Following the U.S. central bank's decision earlier this month to increase interest rates for the first time in more than three years, markets now expect the Fed to get even more aggressive.
Current pricing suggests a half percentage-point hike in May and a cumulative boost of 2.5 percentage points to benchmark rates through the end of the year, from the near-zero level where they started 2022.
Doing that could take a big toll on U.S. growth, said El-Erian, chief economist advisor at Allianz and president of Queens' College, Cambridge.
"The bond market believes inflation is too high, the Fed is well behind the curve, and the Fed risks ... pushing the economy into recession as it tries to catch up," El-Erian told CNBC's "Squawk Box" in a Monday morning interview.
Indeed, some market measures are indicating that recession risks are building.
Some shorter-term government bond yields are running higher then their longer-duration counterparts, historically a warning sign that investors believe economic growth ahead will slow. For instance, the 3-year Treasury note was running ahead of both the 10-year note and 30-year bond in Monday trading.
However, a more reliable indicator has been the relationship between the 10-year and the 3-month note, and that yield curve is well apart. The spread between those yields at the end of last week was still about 1.93 percentage points, a margin that implied only a small chance of recession over the next year.
Still, El-Erian said consumers will be struggling with inflation in the coming months. The Fed will try to contain inflation with rate hikes that could constrict economic growth.
"We are looking at a cost-of-living crisis. That's what we are looking at for the next two quarters, three quarters, where the consumer is going to be hit hard by inflation, they're gonna get hit hard by lower consumer sentiment," he said.
El-Erian noted that U.S. stocks have held up relatively well so far, as there are still few alternatives for investors.
A slew of data points this week will help shed light on how quickly the Fed needs to move.
The Job Openings and Labor Turnover Survey for February, due Tuesday, will give insight on labor market slack. The previous month's report indicated a gap of about 4.8 million between job openings and unemployed potential workers.
On Thursday, the Commerce Department will release the Fed's preferred inflation gauge, the core personal consumption expenditures price index. That is expected to show a 12-month gain of 5.5% in February, above the previous month's 5.2% and well ahead of the Fed's 2% goal.
Then on Friday, the March nonfarm payrolls report is expected to show a 5.5% 12-month increase in average hourly earnings. Economists fear a wage-price spiral that could exacerbate the current 7.9% inflation pace, which is the highest in 40 years.
Consumers flush with cash from pandemic-related stimulus programs have been able to absorb much of the higher costs. But El-Erian said inflation and higher rates will take a toll.
"The corporate sector has pricing power. It has pricing power because demand is still solid. So we'll be able to pass through the higher costs," he said. "Overall, we are gonna go through a difficult period where the cost of living is going to be on everybody's mind."