MNI: Fed's Musalem Sees Limited Room For More Rate Cuts

The Federal Reserve was justified in cutting interest rates last week but still-elevated inflation and a higher neutral rate mean the central bank might not have room to reduce borrowing cuts much further, St. Louis Fed President Alberto Musalem said Monday.

"I believe there is limited room for easing further without policy becoming overly accommodative, and we should tread cautiously," Musalem said in prepared remarks for an event at the Brookings Institution. (See MNI INTERVIEW: Fed Easing Constrained By High Inflation-Sahm)

He said financial conditions are still "supportive of economic activity," and cited concerns about the risk that inflation might prove more persistent than expected, especially against the backdrop of ever-shifting tariff policies. 

"Monetary policy should continue to lean against persistence in above-target inflation, whether it materializes from the impact of
tariffs, lower labor supply growth, or for other reasons," he said. In addition, "the ex ante real policy rate is already close to neutral." 

RISKS TO EMPLOYMENT

After last week's quarter point cut, the nominal policy rate is now 4.1%, Musalem noted. Given markets expect an inflation rate of 3.3% over the next 12 moths, that leaves the real funds rate at 0.8%, "below the 1% median long-run real neutral rate of FOMC."

Musalem said last week's rate cut was warranted because risks to the labor market have risen compared to the risk of more persistent price pressures. The modest pace of growth and low hiring rate suggest the unemployment rate could increase sharply if layoffs were to rise significantly, he said. 

"Recent data indicate that the downside risks to employment have increased relative to the risk of inflation remaining persistently above target," he said. 

However, "overemphasizing the labor market objective runs a risk of excessive policy easing, which could cause a further steepening of the yield curve, a rise in the term premium or an increase in inflation expectations. Any of those effects could do more harm than good to the labor market and contribute to more persistent above-target inflation." 

NON-TARIFF INFLATION HIGH

The effects of tariffs on inflation have been more muted than expected so far, suggesting that factors other than tariffs are contributing to above-target inflation, Musalem said. 

Goods, services and shelter CPI inflation all moved higher on a three-month annualized basis last month, and core services ex-housing, or “supercore” inflation, exceeded 4% for the first time since February, he noted. St. Louis Fed economists estimate a direct passthrough of tariffs to core PCE of 0.2% from January to July, and 0.1% higher including indirect effects, he said. 

Producers of intermediate goods are fully passing on tariffs to their customers but firms closer to the final consumer are less able to do so, Musalem said. Some firms are also waiting to make price adjustments until tariff rates and policies seem set, he said. 

"This suggests the pass-through of tariffs to consumer prices could rise later as final tariff rates become more certain and inventories are re-stocked," he said. 

The risks of persistent above-target inflation would be especially problematic if longer-term inflation expectations begin to move higher, he said. 

But if inflation expectations are well anchored, "overemphasizing the inflation objective runs the risk of not providing enough support to maintain a full-employment labor market at a time when downside risks have risen," he said. "Again, balance is the key." (See: MNI INTERVIEW: Fed Easing Constrained By High Inflation-Sahm)