MNI INTERVIEW: Fed Right To Pause; Fiscal Boost Offsets Rates

The Federal Reserve was right to hold rates in place last week but in the medium-run its job of containing inflation is being made harder by excessive government borrowing, former St. Louis Fed economist David Andolfatto told MNI.

“It did the right thing to pause. I was worried all along that they were moving a little too aggressively,” he said in an interview. “Who knows if it went a little too far.”

Andolfatto said warnings that the Fed would need to inflict significant pain on consumers and businesses had thus far proven misguided as inflation has fallen to just over 3% from peaks above 9% even as the jobless rate hovers near historic lows at 3.8%.

“Chris Waller is looking pretty good here,” he said referring to his former St. Louis Fed colleague who is now a Fed board governor, and who has argued the Fed can achieve better balance in the job market without a major hit to employment.

“It looks like a soft landing so far is what has transpired.” (See MNI POLICY: Softer Trend Inflation Boosts Case For Fed Pause)

FISCAL FOIBLES

Still, over the medium run the central bank is going to have a hard time keeping price pressures at bay unless Congress makes a serious effort to reduce the government’s primary budget deficit, he said.

“Nominal tax revenues are down and a large part of it is evidently that in 2022, because the Fed hiked so aggressively, there were capital losses incurred on stocks and bonds, this translated in a reduction in tax revenues – which is kind of inflationary. Raising interest rates is having the opposite effect,” he said.

“Another inflationary impulse is that it raises the interest expense on the debt.”

If the fiscal situation were working in concert with monetary policy then tax revenues should be moving higher rather than lower, said Andolfatto, now a professor at the University of Miami.

“The outlook for the fiscal situation is not really promising. I don’t see a lot of political forces in place that are serious about doing something about the deficit over the long term. Compounding that is we have very little idea about how global demand for Treasuries will evolve,” Andolfatto said.

The Treasury Department on Thursday reported a USD1.613 trillion budget deficit in the first ten months of the fiscal year, surging by 122% compared with this point last year, and interest costs jumped 23% to a record high.

HIGHER FOR LONGER

Ten-year Treasury yields have hit 16-year highs on expectations that Fed will keep interest rates “higher for longer” and amid concerns about rising debt levels and what they portend for bond issuance. The Fed kept official rates at 22-year high of 5.25-5.5% last week, but signaled another possible hike this year and two fewer cuts in 2024.

“The labor market is still reasonably resilient, inflation is still above target. The Fed is going to remain hawkish and that manifests itself in the forward guidance that we got,” said Andolfatto.

He said getting inflation to around 2.5% for some time would probably be enough to satisfy policymakers, even if they would be loath to officially raise their inflation target. Moving to a target range might be more acceptable, he said. (See MNI POLICY: Fed To Consider Shift To Inflation Target Band)

“We could get a period of above average inflation – overshooting it by 50 or 75 is not the end of the world,” he said.