"If the Fed can do what it wants to do it will stop at around 2 (percent) and the (yield) curve will stabilize and two-year (bond) rates will reflect it, and that means it will sell off," El-Erian said. "But the big question is, can the Fed get what it wants? And what it wants is the financial contraction to stay in the financial sector."
Leading U.S. banks have been hit by billions of dollars in writedowns following the collapse of the subprime mortgage market and the ensuing credit crunch. Wall Street stalwart Bear Stearns had to be rescued by the Fed and JPMorgan Chase , and many analysts see additional writedowns looming ahead.
El-Erian said the overall economy is in for troubling times ahead as consumers feel the continued pinch of inflation, caused in large part by rising fuel and food costs.
"I think what is going to sink the economy if it sinks is inventories are building up in virtually every sector. Profitability is going down and the next natural step is for unemployment to go up," he said. "At that point the consumer is hit by negative income effect and negative wealth effect and a credit crunch."
He also predicted continuing weakening of the dollar as Asian currencies become predominant around the globe.
"The reality is the new bloc of countries that were not important from a systemic perspective are now becoming important," he said. "Part of that is demanding more commodities, and part of that is global inflation."