MNI INTERVIEW: Fed Will Need To Hike Past 5% - Buiter

The Federal Reserve will need to raise interest rates substantially more than investors or policymakers believe, pushing borrowing costs above 5%, in order to bring down inflation, economist and former Bank of England Monetary Policy Committee member Willem Buiter told MNI.

A stronger-than-expected 8.3% jump in CPI in the year to August cemented expectations for further aggressive hikes from the central bank, sending stock markets lower and bond yields higher. It also raised the prospect that the Fed’s new “higher for longer” mantra may mean more tightening than is currently priced in.

“They’re still quite far behind the curve. Inflation is way above target even if you just look at core inflation,” said Buiter in an interview. “Real economic activity is at or above full capacity utilization, the unemployment rate is still at cyclical lows, so monetary policy should be materially restrictive.”

That means the policy rate should be well above the neutral rate when in reality the Fed is just now “edging above the neutral level,” said Buiter, who also served as global chief economist at Citigroup as well as in a series of academic positions.

Core inflation jumped 0.6% last month, double expectations for a 0.3% gain and leaving the year-on-year reading at 6.3%--more than three times the Fed’s 2% target for headline inflation.

As for how high the Fed will need to boost the Fed funds rate in order to bring inflation back to target, Buiter said: “No less than 5% would be my guess. If they did that for a year or so it would probably get inflation out of the system.”

Well-anchored expectations mean the Fed can still bring down inflation without inflicting too much economic harm, said Buiter.

“Inflation expectations very encouragingly have not become unhinged yet,” said Buiter, citing both market measures and consumer surveys like the one published by the New York Fed. “The damage can still be contained but they have to get more serious than they are currently. They talk tough but they’re really still wearing short pants.” (See MNI INTERVIEW: Powell Channels Volcker To Head Off '80s Redux)

TOO LATE FOR A FULL POINT?

Still, Buiter said it was unlikely the Fed would opt for a full point rate hike at next week’s meeting despite some market speculation to that effect following the surprise CPI gains.

“If they were going to do 100 basis points they would have done so already. I wouldn’t completely rule it out, but I’d be very surprised because that is not what any member of either the board or the regional presidents has been hinting at,” he said.

That doesn’t mean that the latest data, and other indicators of both hot inflation and a strong labor market, won’t sway the Fed to be even more aggressive. Buiter thinks they will hike by 75 basis points for the next two meetings, then go down to 50bps in December and persist with further 50bp or 25 bp hikes early next year.

“If they do so it will slow down the economy and could create a mild recession,” he said.

But such actions are necessary in Buiter’s view in order to get inflation back under control.

“There’s enough inflation built in, inflation expectations in the short run are coming down but they’re not 2%, so we are going to see through the labor market, through wage inflation, through the service sector and through other parts of the economy where there is still probably excess demand – certainly labor scarcity – you’re going to see upward pressure on inflation,” he said.

“Core and headline inflation will converge, with headline coming down faster than core inflation for the foreseeable future.”