MNI INTERVIEW: Risk Election Makes Fed Pause-Ex Fed's Tracy

At least two more interest rate hikes and most likely a mild recession are needed to rein in inflation, but next year's presidential election could cause the Federal Reserve to hesitate, Joseph Tracy, former senior adviser to Fed presidents Robert Kaplan and William Dudley, said in an interview.

Real U.S. interest rates are currently just north of 50 basis points, based on the difference between the effective fed funds rate and trimmed mean PCE inflation, which is not high enough to bring inflation back to 2%, Tracy told MNI's FedSpeak podcast.

"Policy is really not that restrictive, which I think is also part of the reason why the U.S. economy has remained fairly resilient. Essentially up to now the Fed has just been taking away accommodation," said Tracy, a nonresident senior fellow at the American Enterprise Institute. "It would take pushing that real interest rate up well above 1% to start having some kind of a bite in terms of slowing the economy down."

But Fed officials will also be well aware that the consequences of additional rate hikes this summer -- likely a mild recession -- will be felt just before the presidential election next year.

"It's the worst possible timing for an incumbent," he said. "My concern is there may be an incentive to leave policy relatively unchanged and hope that the declines in inflation will be what tightens policy going forward, by raising the real rate."

REAL RATE RISES

The Fed should have begun raising interest rates a year earlier than it did and has been playing catch up ever since, Tracy said. It failed to recalibrate monetary policy in response to a supersized fiscal response to Covid-19 that is still working its way through the economy, he said.

"They need to go ahead and raise the fed funds rate at least twice and see if underlying inflation moderates further," Tracy said.

After these additional hikes, even a slow 20-25bp decline in inflation between FOMC meetings would mean policymakers could then hold rates and count on additional gradual tightening via a rising real rate. (See MNI INTERVIEW: Fed's Athreya-Real Rates Might Still Be Too Low)

When they feel the real rate is high enough that it need not rise further, officials will consider rate cuts, he said.

"At that point, they need to at least match in rate reductions what we continue to see in inflation reductions, but they'll probably need to cut a bit faster than inflation is coming down so that they bring the nominal rate closer to the 2.5% long term rate."

HIGHER GOODS INFLATION

The decline in inflation so far vindicates the Fed's earlier call that pandemic-era price surges were transitory, albeit on a longer timeline, but getting down to 2% from 4.5% will be much harder, Tracy said.

Service inflation was above 3% before the pandemic and goods prices were falling. With globalization in reverse gear all around the world, Tracy reckons goods inflation could settle around 2%, meaning more progress would be needed from service inflation to achieve the Fed's 2% goal.

"If it stays well north of 3% as in the past, then the issue is are we really going to get goods prices back into deflation? And I don't see that happening absent a much slower economy," he said.

"It is probably more honest to say, look it's most likely going to take at least a mild recession to get inflation back to target," Tracy said. "There's perhaps too much emphasis on this notion of a soft landing. It would be amazing if that happened but I just don't see it in the cards as a high probability event."