Mohamed El-Erian warns the Fed has lost most of its credibility - and says markets are pricing in more 'collateral damage'

• Sell-offs after the Fed's recent rate hike shows it has lost credibility, Mohamed El-Erian warned.
• That increases the risk of economic pain as tightening continues, according to the economist.

The Federal Reserve has lost most of its credibility, leaving the US at risk of considerable economic pain, according to Mohamed El-Erian.

The economist warned on Wednesday that the Fed's failure to tame inflation this year meant that markets were no longer confident that a US recession could be avoided as it tightens monetary policy.

"Markets see a central bank that expects to cause more collateral damage as it tries to meet its inflation target," El-Erian wrote in a Project Syndicate op-ed. "Jerome Powell said as much this month when he continued to distance himself from the possibility of a soft or 'softish' landing, as he once put it."

The Fed announced its third-consecutive 75 basis point interest rate rise last week as it battles to bring soaring inflation under control.

Powell, the central bank's chair, also warned that the fight against rising prices would "bring some pain" to Americans by slowing job growth and making mortgages and credit cards more expensive.

Stocks have tumbled since his speech, with the benchmark S&P 500 down 3.8% over the past seven days.

The spread in yields between 2-year and 10-year US Treasury notes has also continued to widen, which tends to signal that investors expect a recession.

"Powell has now repeatedly signaled more 'pain' ahead, implying an uncomfortably high probability of recession," El-Erian said. "The market appears to agree with this outlook: the yield curve is inverted, with the yield on 10-year Treasury bonds having fallen to around 40 basis points below that on two-year bonds."

While the Fed is now hiking interest rates aggressively in a bid to tame soaring prices, El-Erian believes it initially lost credibility with markets because it fueled the "everything bubble" of 2021 by keeping interest rates low even as inflation prints started to steadily climb.

"The US needs more monetary-policy tightening than it would have if the Fed had reacted in a timely and credible fashion," he said. "That will indeed produce 'pain' in the form of foregone growth (actual and potential) and higher unemployment, which will hit the most vulnerable segments of society the hardest."

Read more: The Fed is dragging the US into a recession to cool surging prices. Most Americans expect inflation to die down on its own.