MNI INTERVIEW: Fed May Hike More Than FOMC Says - Blanchard

The Federal Reserve might need to raise interest rates even more than it indicated at its September meeting because inflation pressures coming from an overheating economy are likely to prove stubborn, former IMF chief economist Olivier Blanchard told MNI.

The FOMC projected rates rising to a median 4.6% next year in its latest Summary of Economic Projections as inflation remains stuck near 40-year highs.

“There’s a very good chance that they have to do more than they have said, that we see rates go up maybe to 5% or more,” Blanchard, a senior fellow at the Peterson Institute for International Economics, said in the latest episode of MNI’s FedSpeak podcast.

That’s because the unemployment rate, which fell back to a 50-year low of 3.5% in September, is likely well below its so-called “natural” rate, which probably rose following the pandemic shocks that led to labor shortages.

“I think the economy is still overheating. This is a question of what is the natural rate in the US, which is an impossible question to answer but 3.5% is very low,” he said. “There are good reasons to think the natural rate has increased. So I think we are below the natural rate which is putting pressure on wages and prices.”

ROUND TWO

In addition, there are “second round” effects of workers asking for pay raises in order to make up for the ground they have already lost to inflation.

“The combination of an overheating economy and fairly strong catch-up or second round effects is such that behind the scenes, although the headline numbers are likely to look better, there’s still a fairly serious issue,” he said. “Underlying inflation is still fairly strong. So I think the Fed will have to do quite a bit. The economy is not going to slow down on its own, so the Fed will have to slow it down.”

Still, Blanchard praised the U.S. central bank for playing catch up after having fallen behind the curve in its inflation fight last year and earlier this year. The central bank has boosted rates by 300 basis points since March, including three 75 basis point rises in three meetings. Another supersized hike is expected in November.

“At this stage the Fed has more or less caught up and is more or less at the curve,” he said.

At the same time, there are some forces in the global economy putting downward pressure on inflation which should assist the Fed’s inflation fight in coming months, including falling commodity prices and easing supply chain constraints, he said.

RACE AGAINST TIME

Achieving a soft landing is essentially a race against time for maintaining the Fed’s inflation-fighting credibility as the inflation problem drags on for much longer than anyone expected.

“If the news on headline is good, if expectations at the long-end are anchored, then they can go relatively slowly and potentially we can avoid a recession, but that’s a very narrow path,” said Blanchard.

Blanchard said that while the UK’s pension debacle does not have direct repercussions for the U.S. financial system, it serves as a reminder the myriad of risks lurking out there as central banks tighten monetary policy globally. (See MNI INSIGHT: Fed Sees Fin. Stability Policy As Separate From Rates)

“When interest rates move a lot then presumably all kinds of players lose and win and this may have implications that we haven’t thought about,” he said. “We have to be ready for accidents like this.”