MNI INTERVIEW: US Inflation Resurgence Still Possible- Koenig

MNI (WASHINGTON) - U.S. inflation could be stuck in a 2.5%-3% range if demand doesn't moderate and the recent burst of productivity growth fades, the Dallas Fed’s former principal policy adviser Evan Koenig told MNI. 

The Federal Reserve is preparing to begin lowering interest rates this month as inflation has declined. It is right to do so to at least maintain its policy stance, but officials must also stay vigilant to the possibility of a resurgence in inflation, Koenig said.   

"The amount of confidence that inflation is on a downward trajectory to 2% is something I don’t share," he said in an interview. "In fact, there’s remarkably little evidence – not none, but surprisingly little – that policy has been effectively restrictive at all. I’m skeptical of the calls for rapid decreases in fed funds rate." 

Prices have benefited from an expansion in labor supply from immigration and unusually strong productivity growth since the pandemic, but those boosters have likely run their course, Koenig said. With demand as resilient as it's been, "the upside risks to inflation are greater than the downside risks," he said. 

SUPPLY SIDE FADING

Labor market indicators show supply and demand are now in better balance, and most of that has been brought about by supply side developments, including a surge in prime age participation and immigration during the Biden administration to offset the retirement of baby boomers, Koenig said. He saw no sign of the labor market tipping toward recession in recent data.   

Productivity growth in the second quarter was 2.5% annualized, with a year-over-year rate of 2.7%. Over the past two years, productivity growth has registered around 2%, above the Congressional Budget Office's estimate of its longer-term trend. 

Wages and salaries in the second quarter grew 4.2%, according to the Labor Department's employer cost index. "If you think labor productivity growth is 1% going forward, that means 3% inflation. Even if you have 1.5% productivity growth going forward, a solid number, you're still talking about 2.5% inflation," Koenig said. "Still you're talking about upside risk to inflation."   

"The fly in the ointment for significant rate cuts is this confidence on extrapolating inflation going forward," he said. "The thing that’s held inflation as low as it’s running is a surge in productivity and labor force growth, neither of which are likely to continue." (See: MNI POLICY: Fed prefers gradual rates easing if jobs allow)

NOT SO RESTRICTIVE

"If you continue to have demand growth, the path is more likely to be upward than downward," Koenig said. Monetary policy hasn't caused demand to weaken all that much. All measures of nominal demand growth remain at 5% or better with no deceleration in recent quarters, Koenig said. (See: MNI INTERVIEW: US Service Growth To Keep Fed Cuts Gradual-ISM )

Aggregate weekly payrolls, a measure that combines jobs, hours and wages, grew 5.0% in the 12 months through August, and 5.1% over the past six months, according to Labor Department data Friday, suggesting the 50/50 average of GDP and GDI is likely to pick up again in the third quarter, he said. 

The Fed may be amenable to accepting the current situation with inflation around 2.5%, but not if inflation moves up from here, Koenig said. Headline and core PCE inflation were 2.5% and 2.6%, respectively, in July. The Dallas Fed trimmed mean was 2.7% over the year through July.  

"If inflation stays where it is at 2.5%, that would make it easier to argue a temporary pause," he said. "It would be very difficult to allow inflation trends to reverse. Core PCE or trimmed mean starting to drift up from where they are would trigger serious reconsideration of the funds rate path."