MNI INTERVIEW: CPI Drop Won't Stall Hikes-Ex-NY Fed Economist

Federal Reserve officials will likely insist on raising raise interest rates a couple of more times to clamp down on persistent core inflation even with headline price gains fading, former New York Fed economist Gianluca Benigno told MNI.

Investors have pared bets for additional rate increases after data this week showing a drop in headline CPI to 3%, the lowest since March 2021. Core prices slowed to a still-hefty 4.8% annual pace. Fed hawks dominating the FOMC will be unsatisfied with those kinds of figures, Benigno said in an interview.

“I’m not sure they will be happy, especially considering core inflation is still relatively high,” said Benigno, former head of international research at the New York Fed and now a professor at the University of Lausanne.

Fed officials held interest rates steady at 5-5.25% in June while boosting their Summary of Economic Projection forecasts for the peak fed funds rate to 5.6%, implying at least two more hikes this year. They are widely expected to raise borrowing costs again at the end of July and markets are now focused on what might happen in September.

“If I look at the composition of the committee and also if I look at the SEP projections, I would say there is still a hawkish position there going into these meetings.” (See MNI INTERVIEW: Fed Will Likely Hike Rates To 6% Or Above-Plosser)

Much of the inflation drop over the past year is due to factors outside of monetary policy, Benigno said, including falling commodity prices and the resolution of supply chain disruptions. Many past price increases have unfortunately become embedded in other parts of the economy, he said.

“That’s where things are more difficult to adjust and will take a little bit more time,” he said. “The other factor is there hasn’t been any adjustment in employment. The economy is holding up until now, doing relatively well. If you really want to push it back to 2% you really need to cause problems for the economy.”

HIGHER R*

"Monetary policy is not really working too much to bring down inflation,” he said, adding that the neutral rate of interest or R* – one that neither stimulates or stunts growth – may be higher than in the past.

“Maybe we are also in a regime where R* is maybe higher than before it might have been supported by fiscal policy. If you think of it that way then maybe the stance of monetary policy is still not tight,” he said.

The fed funds rate adjusted for inflation has only recently turned positive, he said. Monetary policy can tighten further as price pressures recede because that will mean real rates are still climbing, he added.

“It’s only in the last couple of months that you see positive real rates. The Fed has operated most of this cycle with negative real rates,” he said. “Even if they hold now and inflation drops these real rates will increase, there’s going to be tightening.”

R** AND QT

Benigno, who has pioneered research on the concept of R** – a neutral rate of interest that takes not just economic conditions but also financial stability factors into consideration – said the Fed’s response to the March bank turmoil effectively blunted some of the tightening impact of quantitative tightening.

“QT is something that will lower R**. When there was that episode in March, the Fed’s facility pushed it up,” he said. “With that facility, they made Treasuries like reserves then you push up the (R**) rate. In some way QT with that episode has been delayed.”

The prospect of additional rate increases could revive financial instability risks that fell off the radar in the last couple of months. “That might generate vulnerabilities in other sectors.”