Originally Published: 04 AUG 22 11:37 ET

By Matt Egan, CNN Business

(CNN) -- The Federal Reserve's war on inflation will eventually kill the economic recovery from Covid-19, former Fed official Bill Dudley warns.

The problem is that the Fed began its quest to tame inflation late, leaving the central bank little choice other than to slam the brakes on the economy by drastically raising interest rates.

"Almost certainly there will be a full-blown recession. If we're not in one yet, I think we will be in the next 12 months," Dudley, the former president of the New York Federal Reserve, told CNN in a phone interview.

Recession fears mounted after government statistics last week showed the US economy contracted in the spring for the second quarter in a row.

Although Dudley concedes the US economy has clearly slowed, he doesn't believe it has weakened enough to qualify as a recession — at least not yet. He pointed to "too strong" payroll growth and factory activity.

"It's not broad or deep enough," Dudley said of the slowdown. "What we have seen to date is not sufficient by itself to be a recession."

The unemployment rate remains at 3.6%, near the lowest levels in the past half-century.

However, if the economy continues to weaken later this year, Dudley said it's possible the National Bureau of Economic Research, the official arbiter of recessions, will determine that a recession did begin early this year.

Soft or hard landing?

Federal Reserve officials insist they can still pull off a so-called soft landing — taming inflation without causing a recession.

Despite a series of interest rate hikes, the jobs market continues to grow steadily, albeit at a somewhat slower pace.

"We think there's a path for us to be able to bring inflation down while sustaining a strong labor market," Federal Reserve Chairman Jerome Powell said during a press conference last week.

Yet Powell conceded the task has gotten trickier.

"We know that the path has clearly narrowed, really based on events that are outside of our control," he said. "And it may narrow further."

Dudley: 'They're late'

The Powell-led Fed raised interest rates last week by three-quarters of a percentage point at its second consecutive meeting.

Dudley said the challenge for the Fed is due in part to its own poor forecasting: the central bank didn't begin to raise interest rates until inflation was already very high.

"They got going really slowly," Dudley said. "They're late and that means they have to do more. And that increases the risk of recession. I think a recession is highly likely, and I'll be very, very surprised if they avoid a recession."

The good news is that Dudley is betting any looming recession would be "mild" in terms of the depth of the decline because corporate and household balance sheets are in decent shape.

He did caution however that continued high inflation means the Fed may not be able to swiftly come to the rescue with interest rate cuts aimed at curtailing a downturn.

"It could last longer because it may be that the Fed can't ease off the brakes too quickly," he said.

Is Wall Street misunderstanding the Fed?

Others are a bit more optimistic.

S&P Global Ratings sees a roughly 45% chance of a recession in the next 12 months.

"Whether the US can avoid a recession is a toss-up," Beth Ann Bovino, S&P's US chief economist, wrote in a report Wednesday.

US markets have ripped higher since last week's Fed meeting as investors seized on potential hints from Powell that the central bank may soon be able to slow the pace of its rate hikes.

Stocks have continued to rally despite a flurry of comments this week from current Fed officials signaling the war on inflation is nowhere near over.

Dudley warns investors are misinterpreting the signals from the Fed, adding that he was "a little bit puzzled" by the market reaction.

"The Fed is still far away from the amount of slack they need in the labor market and from the 2% inflation target," he said.

Dudley added that another rate hike of three-quarters of a percentage point is still "potentially in play," depending on how the economy evolves. He expects the Fed will need to raise interest rates to 4% or higher — up from 2.5% today.

All of that runs counter to the enthusiasm on Wall Street.

The S&P 500 finished Wednesday at its highest point in nearly two months, while the Nasdaq has surged to levels unseen since early May.

Dudley warned that the uptick in the stock market may be counterproductive because it translates to easier financial conditions. And that's exactly the opposite of what the Fed wants as it tries to tame inflation.

"Ironically," Dudley said, "the big rally in financial markets increases pressure on the Fed to do more."