Here’s the biggest risk with what the Federal Reserve does with interest rates: Mohamed El-Erian – Yahoo Finance

If the Federal Reserve is too heavy-handed with its interest rate hikes this year as a means to stomp out high rates of inflation, there is one critical risk that most investors probably aren't factoring in.

Recession.

"That is the risk [of a recession in 2023]," said Mohamed El-Erian, Queens' College, Cambridge University president and Allianz advisor, on Yahoo Finance Live. "We haven't had a situation in the past in which the Fed has been really late [with rate hikes] and the Fed hasn't ended up tipping the economy into a recession that's why we want to avoid that outcome."

Market participants widely expect the Fed to lift rates three times this year, and conclude their bond-buying program by March. But the timing of those interest rate increases could be pulled forward given continued hot inflation readings.

Investors bore witness to eye-popping levels of inflation in 2021 as workers (in short supply) demanded higher wages, ports were clogged due to the pandemic, home prices ripped higher and gas prices marched upward.

In November, the headline Consumer Price Index (CPI) clocked in growth of 6.8%. That marked the fastest rate of inflation since 1982.

Bond manager DoubleLine told Yahoo Finance Live this week it sees headline inflation coming in at 4% in 2021. The upcoming CPI print could show a headline gain of 7%.

"I don't think we are going back to the old school one and a half to 2% inflation because it's permeated the psyche for a period of time. And so I think we are going to have to deal with higher levels of inflation, and the front end of the bond curve is telling you that if you look at breakeven spreads," DoubleLine co-chief investment officer Jeff Sherman said on Yahoo Finance Live.

The sticky inflation and subsequent actions from the Fed is leading to the likes of bond king Jeffrey Gundlach and El-Erian to raise the specter of a recession within the next 24 months. In turn, it could be a volatile road for investors ahead after an impressive 2021 for markets.

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"This is obviously painting a tricky picture for both the economy and for markets," El-Erian added.

Brian Sozzi is an editor-at-large and anchor at Yahoo Finance. Follow Sozzi on Twitter @BrianSozzi and on LinkedIn.

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Here's the biggest risk with what the Federal Reserve does with interest rates: Mohamed El-Erian - Yahoo Finance