MNI INTERVIEW: Fed Pause Could Make Inflation More Entrenched

A possible pause in interest rate hikes from the Federal Reserve in June, seen as more likely after this week’s FOMC decision and an accompanying statement that was more equivocal about future increases, could lead to more deeply embedded inflation pressures that might require even tighter policy down the line, a former top Fed staffer told MNI.

Andrew Levin, who spent two decades as a Fed board economist, said Fed Chair Powell’s dovish hints that a pause could be forthcoming, including the argument that real interest rates are already substantially positive, fail to take into account still-elevated short-run inflation expectations of consumers and businesses.

“There’s a very substantial possibility that inflation is going to remain elevated as far as the eye can see,” he said. Levin pointed to the Cleveland Fed's "indirect" measure of consumer inflation expectations over the next 12 months at 5.4%.

“Probably at the end of this year and into next year these deep underlying measures of inflation are still going to be running in a range of 4-5%. What are they going to do to bring inflation down below 4%? A federal funds rate of 5% is probably not going to be enough to make much of a difference.”

The Fed this week hiked interest rates to a range of 5-5.25%. Chair Powell argued monetary policy is tight because comparing market-based expectations of inflation one-year out of around 3% versus the fed funds rate yields a real rate of around 2%. “That’s meaningfully above what many people would assess as the neutral rate,” he said.

CONFLICTING SIGNALS

Levin, a former aide to Fed Chair Janet Yellen, said Powell’s reasoning makes sense only if you believe market based expectations – but he sees reason for skepticism.

“We’re getting conflicting signals. The 3% is the Federal Reserve itself and professional forecasters and former Fed economists who are now chief economists at a lot of private sector firms that all have very similar views – they’ve been wrong for two consecutive years, wrong about how fast inflation would come down,” he said.

“Consumers just don’t see it the same way. If the consumer is proven yet again to be right, then a 5% federal funds rate is not tight, it’s neutral," he said. Consumer surveys from the University of Michigan and the New York Fed both showed year-ahead inflation expectations surging in April.

Levin says that by even hinting at a pause the Fed has limited how much further room it has to raise rates further without significantly disrupting markets. Barring a significant worsening of the regional banking crisis and a substantial recession, he said, the Fed might still be forced to deliver one or two more hikes later in the year. (See MNI INTERVIEW: Fed To Resume Hikes Later If Inflation Lingers)

“If inflation stayed high and the economy is still growing moderately, then I think the communications they’ve been making lately could leave the door open to making a couple more quarter point hikes. Maybe they get up to 5.5% or 5.75% this year. That’s still not a very tight monetary policy if inflation is still at 5%.”

“The problem will get harder and harder for the Fed. Next year is a presidential election year so it would be hard for the Fed to take decisive action,” he said.

STAGFLATION, NOT RECESSION

In part because of the Fed’s timidity in fighting inflation in the face of financial instability, Levin still thinks the economy could skirt a recession.

“There are some strains from the bank failures [and] those might affect the lending behavior of banks, those might have other spillover effects from credit markets. But the signs we got from the services PMI and probably in the employment report tomorrow, the economy is doing ok,” he said. “Probably the better description is something like stagflation."