Top economist Mohamed El-Erian says the Fed will face these two ‘unpleasant choices’ next year

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Over the past year, investors and economists have repeatedly criticized the Federal Reserve for its aggressive interest rate hikes aimed at lowering inflation.

Mohamed El-Erian—the economist who was once CEO of Pimco and is currently the president of Queens’ College at the University of Cambridge—has been one of the central bank’s biggest detractors, consistently slamming the Fed for being late to act against inflation. Inflation, as measured by the consumer price index, is currently at 7.7% after peaking at 9.1% in June. 

“The Fed is still playing catch-up to tame rising prices after its protracted gross mischaracterisation last year of inflation as ‘transitory’ and its initially timid steps to withdraw monetary stimulus,” El-Erian wrote in an op-ed for the Financial Times published on Sunday.

One of his chief complaints is the 2% inflation target that the Fed established in 2012 as the ideal level. The target, Bank of America recently said, provides “buffers” for policymakers, in that it leaves room to lower interest rates during an economic downturn while also largely reducing the risk of deflation. 

El-Erian echoed the reasoning behind the target—but argued that because of it, the Fed will soon find itself in a difficult position.

“The world’s most powerful central bank is now confronted with two unpleasant choices next year: crush growth and jobs to get to its 2% target or publicly validate a higher inflation target and risk a new round of destabilized inflationary expectations.” 

El-Erian isn’t the only prominent critic of the Fed’s 2% target. Both Barry Sternlicht, CEO of private investment firm Starwood Capital Group, and economist William Spriggs have previously told Fortune that the Fed’s commitment to its target could push the economy into a recession. Sternlicht called the target “arbitrary,” and Spriggs said, “There’s nothing written in stone that says inflation is supposed to be limited to 2%.”

But the personal consumption expenditures price index, which is what El-Erian said is the Fed’s preferred inflation measure, is still three times more than the Fed’s target. PCE is based on data from businesses, while CPI sources data from consumers; both indexes measure spending, but the PCE does so on a much broader scale. 

Meanwhile, accelerating wage growth and strong monthly job gains suggest inflation could continue to “overshoot” the Fed’s forecast, El-Erian said.

“Rather than fall to 2-3% by the end of next year, U.S. core PCE inflation will probably prove rather sticky at around 4% or above,” El-Erian said. “This is what happens when an inflationary moment is allowed to get embedded into the economic system.”

A 3% to 4% inflation target would be more reasonable, El-Erian said, given the instability of supply, the transition away from fossil fuels (likely because the transition itself can be costly), and an extended period of nearly zero interest rates. 

What could be happening is that the Fed is publicly signaling a 2% target, but could instead pursue a higher number and hope the public accepts it, he said. However, if that were to happen, he said, the Fed would risk raising more concern over its “accountability, credibility, and autonomy.”

“Yet, given the extent of economic uncertainty and financial fragilities, the Fed could end up thinking that this far from perfect policy approach may be the better course of action,” El-Erian wrote. 

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