MNI INTERVIEW: Rates May Have To Exceed Neutral-Fed's Giannoni

U.S. inflation pressures show some early signs of retreat as Fed tightening begins to slow demand, but elevated energy prices and continued supply chain disruptions raise the likelihood of having to take interest rates above neutral to tame inflation, Dallas Fed research director Marc Giannoni told MNI.

Although CPI hit another four-decade high in March as gas prices surged after Russia's invasion of Ukraine, core inflation cooled on a month-on-month basis, but Giannoni said it was too early to say price rises had peaked. More expensive oil and supply chain snags are likely to persist for some time, contributing to the risk that higher inflation becomes built into the expectations of consumers and firms’ price-setting behavior, which would require a monetary policy response.

Financial conditions have already tightened substantially on expectations of more aggressive monetary tightening, he noted in an interview.

"Over the next eight or nine months, we'll see to what extent the adjustment that's already taken place will help move the economy in the right direction, or instead if we'll see further inflationary pressures and continued acceleration in demand, in which case we'll probably need to make some adjustments" to the fed funds path. This could call for rates higher than the neutral level around 2%-2.5%, he said.

"I trust that inflation will come down from where it is, and the Fed is determined to bring inflation back to its 2% target," he said.

ECONOMY AT VULNERABLE POINT

The Dallas Fed expects headline PCE inflation to end the year at around 5%, with core PCE dipping to 4.5% and falling into 2023. Growth should slow to a still robust 2.5% to 3% this year, as the U.S. settles into a soft landing.

Still, any further shocks would hit the economy at a vulnerable point.

"The probability of a recession is likely a little higher now than it has been,” Giannoni said.

The Fed faces a tough challenge to bring down inflation amid continued turmoil in global trade links. Supply chain disruptions are still "top of mind" for firms in the Dallas Fed region, evidence that the supply-demand imbalance remains fairly large, Giannoni said. The Ukraine war and Covid lockdowns in China have exacerbated the situation, and even a quick resolution to the Russia-Ukraine conflict would leave an economic impact "for a long time."

With CPI running at 8.5%, "we’re in a riskier situation now in looking through the current oil price spike on inflation, because there's a bigger risk that the elevated readings we've seen will translate into higher inflation expectations,” the economist said.

"While oil prices will not necessarily go up a lot from here and therefore not contribute to high inflation in years to come, they will contribute to high inflation this year," and prices are likely to remain high.

SUPPLY CHAIN PESSIMISM

Dallas Fed surveys show little evidence of expectations that supply chains will improve this year. Instead, respondents have in survey after survey extended the horizon at which they would see the constraint easing.

“It's always a year and half down the road," Giannoni said.

But, while rising oil prices have raised input costs and made it more costly for consumers to buy goods and services -- they are also benefitting oil suppliers in the Dallas Fed district.

Texas employment has exceeded pre-pandemic levels, boosted by accelerated migration into the state during the pandemic. Production capacity is increasing and labor market pressures relaxing somewhat, Giannoni said.

The Fed is widely expected to raise its benchmark rate by a half point to a target range of 0.75% to 1% on May 4 and begin trimming its holdings of government bonds as soon as June to help curb demand.