(RPT)MNI INTERVIEW: Sticky Prices Could Require More Fed Hikes

(Repeats article first published on May 10)

There is a significant risk U.S. inflation will not come down as quickly as the Federal Reserve expects this year, forcing the central bank to raise rates further despite strong market expectations for a pause in June followed by rate cuts not long after, senior Dallas Fed research economist Enrique Martinez-Garcia told MNI.

“There’s a nontrivial risk that things could get more difficult and more challenging for the Fed to manage. Policymakers might have to consider whether or not the current path is sufficient to keep inflation on track," he told MNI’s FedSpeak podcast.

Such an outcome would raise the chances of a recession, as well as heightening the prospect of additional financial stresses following a number of sizable U.S. bank failures since March,

“If it turns out that inflation is indeed stickier than we are anticipating right now and that requires monetary policy to become even tighter, then the financial and labor market stresses are likely to be higher and I would expect the chances of a harder landing to be higher,” he said. (See MNI INTERVIEW: Fed Pause Could Make Inflation More Entrenched)

One major impediment to the Fed’s ability to bring inflation back down to its 2% inflation target in timely manner is a labor market that is still ultra-tight despite some modest loosening around the edges, Martinez-Garcia said. That post-Covid dynamic is keeping wages too lofty to be consistent with price stability and increases the risk that inflation expectations could become unanchored.

TOO MUCH OF A GOOD THING

U.S. employers added 253,000 jobs in April, beating Wall Street expectations for some 12 months in a row, while the unemployment rate sank to match a 50-year low of 3.4% again and wage growth picked up.

“The fairly robust growth in wages which has continued, is not accelerating but is still very high and quite persistent,” Martinez-Garcia said. “This is particularly relevant for the sectors that are labor intensive and in particular for industries in the service sector that are heavily dependent on labor and the wage scale is going to be a very important part of their cost structure.”

Fed Chair Jerome Powell has emphasized the importance of seeing a decline is service costs outside of the housing sector, which he argued in his post-meeting press conference last week “really hasn’t moved much.”

The Dallas Fed researcher argued that “if we are going to see moderation in headline inflation consistent with expectations of the central bank we should expect to start seeing signs of service inflation slowing down sooner rather than later, otherwise mechanically it’s just going to be difficult."

HOUSING FACTORS

Martinez-Garcia, an expert on housing, said dynamics in a sector that reached bubble-like conditions during the pandemic, will also be key to how fast inflation can come down.

“The cooling of a housing market and housing trends is also going to be mechanically key for the Fed to achieve its stated goal of bringing inflation closer in line to its target by the end of the year, beginning of next year,” he said.

U.S. CPI extended its decline in April, dipping to 4.9% on the year. But the core measure remained quite elevated at 5.5% Shelter prices were the largest contributor to headline inflation.

While long-term inflation expectations are still well-anchored, Martinez-Garcia said that should not be reason for complacency because the longer prices stay high, the more workers and businesses will start to build in higher inflation expectations into their wage negotiations and pricing structure.

“The big lesson that policymakers learned from the 60s and 70s is that if you let those cost-push pressures go without responding you run the risk that while temporary, they might be persistent enough that they start changing the way agents react to inflation," he said.

The Fed raised interest rates last week to a 5%-5.25% range and opened the door to a possible pause in June, although officials have certainly not yet committed to stopping hikes for now.