MNI INTERVIEW: Fed Patient On Cuts As Inflation Sticky-Hetzel

Federal Reserve policymakers can take their time before deciding when and even if to begin cutting interest rates this year because the economy remains strong and the neutral rate has likely risen substantially, former Richmond Fed economist Robert Hetzel told MNI.

U.S. inflation pressures are looking more persistent than officials had hoped, particularly in the service sector, which should give them pause about potentially loosening too early and then having to hike again later if inflation resurges, said Hetzel.

“It does look like inflation hasn’t completely burned itself out. It looks like inflation is going to hang sticky at somewhere above 2%,” he said in an interview.

“The funds rate is probably going to be coming down over the course of the year, but not as much as markets expect. Markets are too optimistic about the number of funds rate cuts and how soon they're going to come,” said Hetzel, a former senior economist and research advisor at the Richmond Fed, and author of “The Federal Reserve, A New History”.

He was speaking after CPI and PPI reports this week both proved hotter than expected, raising questions about whether the Fed’s criteria for having sufficient additional confidence in the downward path of inflation is being met – year-on-year core CPI remains at 3.8%.

One key benefit for the Fed is that inflation expectations have largely been well behaved, which gives them wiggle room to potentially ease conditions without losing credibility, Hetzel said.

“We're in really good shape from that point of view, but now, we still have to get monetary policy right so that we can validate those expectations of price stability,” he said.

“Each FOMC meeting is really a prayer meeting. They're just hoping that inflation stays low enough.” (See MNI INTERVIEW: US Productivity Boom Can Mask Price Pressures)

HIGHER NATURAL RATE

Hetzel said lack of clarity surrounding the level of the neutral rate of interest means monetary policy could actually be less restrictive than policymakers think, despite their aggressive rate hikes in the fed funds rate to a 23-year high of 5.25-5.5%.

“Wealth is quite high because the stock market’s on a tear, housing prices just keep going up. That to me suggests that the appropriate funds rate, the funds rate which gets aggregate demand right and matches the natural rate of interest is probably way higher than it was,” said Hetzel.

Given that uncertainty, he advocates a policy of “leaning against the wind” of persistent inflationary pressures by keeping rates higher for a bit longer.

“The economy's growing maybe a little too strong because underlying inflation isn't coming down the way we want,” he said. (See MNI INTERVIEW: Hard To Rule Out More Fed Rate Hikes-Acharya)

GUIDANCE, NOT A ROADMAP

Hetzel, who worked on his doctoral dissertation under Milton Friedman and proudly describes himself as a monetarist, argues the Fed’s forward guidance and Summary of Economic Projections do not offer enough information about how the central bank might react to scenarios outside its baseline.

That leads to market volatility surrounding policy expectations of the sort that transpired in recent months as markets went from pricing in as many as six rate cuts this year to debating the possibility of none at all.

“Forward guidance [says] this is our best guess at what the funds rate is going to do given our best guess of what the economy is going to do,” he said. “But that's not a reaction function that doesn't tell you what, what the Fed is going to do. If the data come in, in a way that markets don't anticipate.”