StL Fed’s Musalem: Must Lean Against Inflation If Expectations Become Unanchored

– May Have To Leave Rates Unchanged Longer Or Hike Rates If Inflation Worsens

By Steven K. Beckner

(MaceNews) – Although downside risks to the labor market have increased, so have upside risks to inflation and inflation expectations, and such a combination could create a difficult monetary policy dilemma, St. Louis Federal Reserve Bank President Alberto Musalem warned Wednesday.

While allowing for a resumption of interest rate cuts if the economy and/or labor market soften further, he allowed for extending the current “modestly restrictive policy” for a longer period, or even tightening policy if inflation and inflation expectations worsen.

Musalem, a voting member of the Fed’s rate-setting Federal Open Market Committee, said the FOMC would prefer to take “a balanced approach” when both inflation and employment diverge from its goals, but he said that would become difficult if longer term inflation expectations become “unanchored.” Should that happen, he said the FOMC would have to focus on fighting inflation, not on growing the economy.

For the time being, Musalem, a voting member of the Fed’s rate-setting Federal Open Market Committee, said the Fed should take “a patient and vigilant approach” in pursuit of its dual mandate of maximum employment and price stability.

He told the Paducah, Kentucky, Chamber of Commerce he will be paying particularly close attention to longer term inflation expectations, noting some indications they have risen lately.

Although higher tariffs are likely to have limited direct effects on inflation, “indirect, second-round effects” on inflation could be more persistent and worrisome, Musalem cautioned

Musalem was speaking a week after he and his fellow Fed policymakers voted to leave the federal funds rate unchanged in a target range of 4.25% to 4.5%., while tilting toward further rate cuts. The 19 FOMC participants projected the policy rate will end 2025 at 3.9% (a range of 3.75% to 4.00%) in the quarterly Summary of Economic Projections – the same as in the December SEP.

Following the March 19 meeting, Chairman Jerome Powell repeated his belief that monetary policy is “in a good place” and that the FOMC needs be in “no hurry” to cut rates. He called the economy and labor markets “solid,” while expressing concern about the potential for tariffs to increase inflation, if only in a “transitory” fashion. The combination of increased inflation and slower growth forecasts in the SEP “cancel(led) each other out” and led officials to leave their rate projections unchanged, he said.

Powell continually emphasized “heightened uncertainty about the economic outlook,” given market-shaking changes in trade and other policies propounded by President Trump since his inauguration. “(I)t’s just …. really hard to know how this is going to work out…”

“(W)e think our policy is in a good place … where we can move in the direction where we need to,” he continued. “But in the meantime, it’s really appropriate to wait for further clarity, and of course, … the cost of doing that, given that the economy is still solid, are very low.”

Like Powell, Musalem stressed economic and policy uncertainties, particularly with regard to tariffs, and suggested that the FOMC will have to be very careful how it responds, lest it make a policy mistake. He put particular emphasis on inflation expectations.

For the present, he said, “If the economy remains strong and inflation remains above our target, then I believe the current, modestly restrictive policy will remain appropriate until there is confidence inflation is converging to 2%.”

But the appropriate policy stance could change, depending on how things evolve, he added. “If the labor market remains resilient and the second-round effects from tariffs become evident, or if medium- to longer-term inflation expectations begin to increase actual inflation or its persistence, then modestly restrictive policy will be appropriate for longer or a more restrictive policy may need to be considered.”

On the other hand, “If labor market conditions were to deteriorate, with inflation stable or declining toward target and inflation expectations anchored at a level consistent with 2% inflation, policy could be eased further,” Musalem said in prepared remarks.

“At this juncture, a patient approach, involving careful assessment of incoming information, the outlook and risks, will help us as we seek maximum employment, price stability and a durable economic expansion,” he continued.

For the SEP, Musalem said he had both lowered his GDP growth forecast and increased his inflation forecast after noting that already “recent convergence toward the target has been little, even before potential tariff effects.” He declined to give his funds rate “dot.”

He warned that “the risks that inflation will stall above 2% or move higher in the near term appear to have increased.”

What’s more, Musalem noted that “near-term inflation expectations have risen, with higher tariffs often cited as the main driver.”

“Thus far, market data and surveys suggest that longer-term inflation expectations have not risen appreciably and have in fact been stable, but the most recent University of Michigan survey of consumers is a notable exception,” he added.

Musalem expects “the economic expansion will continue at a moderate pace, the labor market will remain healthy around full employment, and inflation will decline to 2% by 2027.”

“However, I see the risks as skewed toward some further cooling of the labor market and inflation remaining above 2% or possibly rising in the near term,” he went on, adding that “a scenario involving labor market softening and above-target or rising inflation would present a challenging environment for monetary policy.”

Tariff increases complicate the Fed’s job, Musalem made clear. While the “direct effects” of higher tariffs on imported goods would likely have limited, “one-off” effects, he said, indirect effects “could contribute to more persistent underlying inflation through second-round effects on non-imported goods and services.”

For monetary policymakers, “it could be appropriate to ‘look through’ direct effects of higher tariffs on the price level,” but said it may need to “lean against indirect and second-round effects.”

Musalem, who succeeded Jim Bullard as head of the Fed’s eighth district nearly a year ago, cautioned his listeners to “be wary of assuming that the impact of tariff increases on inflation will be entirely temporary, or that a full ‘look-through’ strategy will necessarily be appropriate.”

“I would be especially vigilant about indirect, second-round effects on inflation. I would also be uncomfortable if medium- to longer-term inflation expectations begin to rise,” he went on, adding “With inflation already above 2% in a full-employment economy, the stakes are potentially higher than they would be if inflation were at or below target.”

Musalem said it is “probable” the economy will face both slower growth and higher inflation, although he said he is expecting neither recession nor stagflation. But he suggested that wouldn’t be a big problem so long as longer-term inflation expectations are well anchored. Then, “monetary policy can be responsive to both sides of the dual mandate…”

If the Fed were to face weaker growth and higher inflation, he acknowledged “that presents some challenges for monetary policy…both sides of mandate working in opposite directions, and we only have one instrument.”

In such a situation, he said the FOMC would “adopt a “balanced approach.”

It would be “setting interest rates with a few things in mind,” he explained. “Understanding how far off we are from the employment/growth side of the target..and how far off inflation is from the target and balance that.”

He said the FOMC would also need to “consider what is the convergence time..for those two variables. That’s the balanced approach.”

However, Musalem emphasized that the key is keeping medium- to longer-term inflation expectations “well anchored.” The worst of all possible worlds, he suggested, would be if tariffs or other factors drove up inflation while at the same time hurting the economy in a climate of rising longer term inflation expectations.

“That balanced approach works well when inflation expectations are anchored,” he elaborated,but “if inflation expectations threaten to become unanchored or are unanchored, then the balanced approach may not work…”

Then, “we would probably have to lean into the inflation side to make sure inflation and inflation expectations remain anchored,” he said, because “ultimately, we cannot generate full employment if inflation expectations are not anchored.”

Following up on Musalem’s comments in a media scrum, MaceNews asked him whether he believes the FOMC should fight inflation even at the cost of recession if inflation expectations become unanchored in a climate of economic weakness and elevated inflation.

Musalem responded by suggesting the FOMC would have little choice but to focus on fighting inflation. “It is very difficult to achieve maximum employment without price stability,” he replied. “That’s the reason why if inflation expectations were to rise or become unanchored, the balanced approach may no longer be the best approach.”

Were inflation expectations to become unanchored, “we would probably have to think a little harder about the price side of the mandate,” he also told reporters.

Inflation expectations have become an increasingly touchy issue for Fed policymakers, especially since the University of Michigan disclosed that its consumer sentiment survey found that five to 10-year inflation expectations had risen to 3.9% in February — highest reading since 1993.

Last Wednesday, Powell continued to call longer term inflation expectations “well anchored,” referring to a leap in the University of Michigan’s five-to-10-year measure as “an outlier.”

Earlier this week, New York Fed President John Williams also said, “there are no signs of inflation expectations becoming unmoored relative to the pre-pandemic period.”

But Musalem is not the only one who sounds less sanguine. Fed Governor Adriana Kugler said on Tuesday she is “paying close attention to the acceleration of price increases and higher inflation expectations, especially given the recent bout of inflation in the past few years.”