MNI INTERVIEW: Inflation Risks To Keep Fed Cuts Gradual - Reis

MNI (WASHINGTON) - Risks of new inflationary shocks and a higher neutral rate mean the Federal Reserve is likely to cut U.S. interest rates gradually and not all that much, Ricardo Reis, London School of Economics economist and academic consultant at the Richmond Fed, told MNI. 

“There's not a particular reason for the cuts to be all that fast,” he said in the latest episode of MNI's FedSpeak Podcast. 

He questioned financial markets’ rationale for speculating about 50-basis point rate cuts, arguing the unemployment rate has merely “inched” higher and inflation was coming down steadily toward the Fed’s 2% target but is not at any particular risk of undershooting it. 

“Given that it seems like a steady pace of 25 basis point cuts – as is a norm in monetary policy – throughout the end of the year, seems much more in line than rushing toward a 50-basis point" move, said Reis, who is also a consultant for the Bank of England and the Riksbank. (See: MNI INTERVIEW: Fed's Harker Ready To Start 'Methodical' Cuts) 

HIGHER NEUTRAL RATE 

The Fed’s cuts are likely to be relatively shallow in this cycle, said Reis, in part because the neutral rate is probably higher than policymakers think. 

“The Fed will discover as it starts cutting that the point at which monetary policy is neutral is not 2%-2.5% as it used to be. It’s not even 2.5%-3% as some of the SEPs are suggesting, but maybe significantly higher, say 3.5%-4%. As a result, once we start cutting we won’t cut all that much,” he said.  

Another reason to be gradual is that Reis still sees more threats to the upside on inflation than to the downside. 

"I do think that inflation is on its way back to 2%, it’s decisively gone there. If you would ask me to forecast inflation, say 12 to 18 months from now, I would say 2%. However, this is absent shocks,” said Reis. (See MNI POLICY: Fed Increasingly Convinced It Defeated Inflation)

POTENTIAL SHOCKS

“Shocks will come. I see those shocks as being more on the upside than on the downside right now. Therefore I think we are more likely to overshoot than undershoot that target.”

Potential risks include whatever economic policy mix follows this year’s U.S. presidential elections, as well as a growing threat of trade protectionism not just from China but also the European Union, said Reis. 

“Whichever way it goes, whether we think about tariffs, immigration, industrial policy or even some of the suggested changes in tax rates – these all have a potentially large impact on the amount of labor in the economy, relative prices and relative incentives to work and to produce that will show up as precisely supply shocks,” he said. 

“I would emphasize the EU as a source of shocks. The EU is really moving towards a very interventionist industrial policy, catching up, if you want, with what China has been for a while, and the U.S. with what President Biden did.”

Reis said the Fed’s shift in emphasis toward the threat of higher unemployment is a natural result of the decline in inflation, which leads to an increased need for balance on the two sides of the Fed’s dual mandate. He doesn’t think the jobless rate is likely to rise much further, and believes the economy and consumer spending are cruising along, even if the last couple months of data have shown hints of softness. 

“I don’t expect unemployment to increase all that much,” Reis said.