MNI INTERVIEW: Fed Could Hold Longer On 'Entrenched' Inflation

Persistent inflation in services and housing could force Federal Reserve officials to push off the start of interest rate cuts until later in the year, former Fed board economist Andrew Levin told MNI.

“Supercore prices in the service sector and rental rates in the housing market are leveling off at levels that are not consistent with the Fed’s inflation target,” Levin said in an interview.

The December CPI report released Thursday showed core services excluding housing, which Fed Chair Jerome Powell has flagged as a key metric, still hovering above a 4% annualized pace, while high shelter costs continue to defy predictions of an imminent reversal.

“To the extent that the Fed starts cutting, it probably creates an impetus for those components of inflation to continue for the foreseeable future,” said Levin, who was special advisor to the board on policy and communications.

“Fed officials used to talk about their worries about inflation getting entrenched. When I look at the data, it seems like inflation has become entrenched in the service sector.” (See MNI INTERVIEW: Bullard Says March Is Too Early For Fed To Cut)

In addition, wage growth is still running above levels which policymakers see as consistent with price stability, Levin said.

“Wage growth also looks like it’s leveling off around two percentage points higher than it was prepandemic,” he said. “If the unemployment rate stays below 4% and payroll growth stays around 100,000-150,000 per month, then there won’t be any downward pressure on nominal wage growth.”

That means officials’ description of the current stance of monetary policy as restrictive is misleading, Levin said.

“Policy is not tight. Policy is not restrictive. It’s a mischaracterization for the Fed to say that,” he said.

ADVERSE SCENARIO

Levin sees two main ways that the outlook could develop over the course of 2024. Inflation could fall more quickly than he and policymakers expect in the first couple of months of the year, giving the central bank room to start cutting interest rates in May or June.

That’s less aggressive than markets expect – investors foresee as many as six rate cuts this year even though the Fed’s December Summary of Economic Projections in December penciled in just three.

“Maybe in the next three to six months supercore services and rental rates do start to come down. Then by May or June the Fed is right to ease and it ends up not so different than what markets are currently expecting. Maybe it’s not six cuts, it’s only four but maybe they throw in a 50-basis-point cut in there.”

For Levin, the bigger worry is an alternative world where services, shelter and wage inflation remain high or even accelerate, which would force policymakers to reconsider the timing of cuts.

“In this alternative scenario the Fed may not cut at all, or they could cut once or twice just symbolically but emphasize that they’re not prepared to ease too much because core inflation is still too high,” he said.

Stubborn housing inflation could prove particularly problematic given how much policymakers are counting on it to fall.

“My guess is it’s going to take years for existing leases to catch up to house prices. I wouldn't be surprised if the rental component of the CPI stays high for a very long time,” Levin said.