MNI INTERVIEW: Fed's Garriga Urges Stay Tough On Inflation

The Federal Reserve needs to stay tough on tightening policy as necessary because the longer high inflation persists, the more positive income effects from improved household balance sheets are likely to linger, fueling demand and generating further price pressures, St. Louis Fed research director Carlos Garriga told MNI.

Americans accumulated more than USD2 trillion in excess savings during the pandemic, some of which has yet to be spent. Many households also improved their cash flow by locking in rock-bottom mortgage rates during Covid, a benefit that grows over time as high inflation reduces the real value of debt and real wage growth stays positive.

"For the borrower, it's less money in real terms that they have to take out of their paycheck. If wages are keeping up with inflation, the gap keeps getting bigger over time the longer you have inflation above target. That’s why we need to get at it quick, because we want to make sure that effect doesn’t play out for a long time," Garriga said in an interview.

"My perspective for the last two-plus years has been: let’s be aggressive with inflation, and we’ll be able to drive rates to a neutral level when inflation has clearly converged to target. And that view hasn’t changed."

SAVINGS PILES

Roughly a third of outstanding mortgage balances was refinanced during the "refi boom" of 2020-2021, and an additional 17% were refreshed through home sales, according to a recent New York Fed analysis.

The prevalence of fixed-rate mortgages, unique to the U.S., is a key reason why higher interest rates have less of an effect on U.S. household credit. Garriga explored the role of mortgage finance in monetary policy transmission in a 2017 research paper which found the income effect mechanism is "much more dominant" than the traditional Phillips Curve relationship when inflation persistence is high.

"It keeps the economy growing more than you expect," he said. "The cost of borrowing is more expensive, but you have excess savings earning a higher yield, and the second effect coming out of excess income dominates the higher prices."

STICKY INFLATION

The disinflationary process, which started over a year ago, still has some ways to go, Garriga said. A sizeable chunk of the CPI basket has moved down close to the Fed's 2% target, but core services prices are proving stickier than the rest.

"During the inflation period, the distribution of price changes shifted to the right. As they come back down, they’re not all coming in sync," Garriga said. "The core services categories are moving substantially slower. They may not be the highest, but we’ve never seen them moving down as slow as they have in the recent past."

St. Louis Fed economists have held a more optimistic forecast on growth than the FOMC median since the second half of 2022 and recent data have been consistent with expectations, Garriga said. The staff's forecasts haven't shifted much since the June projections.

"This is a very healthy labor market. Together with a little bit of productivity growth, it’s fueling the economy," he said. "It's hard to have an unemployment rate of 3.5% and a looming recession."

HIGHER FOR LONGER

Economists are increasingly divided over whether the U.S. central bank should continue to raise rates, with some arguing for holding at the current 5.25%-5.5% target range to allow gradual disinflation through rising real rates as inflation recedes and others urging more hikes to quash inflation quickly. (See: MNI INTERVIEW: Prudent for Fed To Hike Another 50-100BP - Reis)

The "higher for longer" argument is grounded on Milton Friedman's "long and variable lags" theory, which may no longer apply in the same way to the modern economy, Garriga said. Fed communications are much more transparent, and financial markets much quicker to react, something Fed Chair Jerome Powell has often noted.

"Theory tells you that when combating inflation, be aggressive," he said. "Higher for longer is not a theory."