MNI: Fed's Musalem Calls For Patient Stance, Flexible Response

The Federal Reserve should wait and see how the U.S. outlook and risks evolve before adjusting monetary policy, which could call for more restriction, maintaining restriction, or easing depending on how inflation and the labor market evolves, St. Louis Fed President Alberto Musalem said Wednesday. 

He outlined three scenarios which would warrant different responses from the Fed in a speech prepared for an event in Paducah, Kentucky, adding that "a patient and vigilant approach" and careful assessment of incoming data will aid the Fed at this time.

"If the economy remains strong and inflation remains above our target, then I believe the current, modestly restrictive policy will remain appropriate until there is confidence inflation is converging to 2%," Musalem said. 

"If the labor market remains resilient and the second-round effects from tariffs become evident, or if medium- to longer-term inflation expectations begin to increase actual inflation or its persistence, then modestly restrictive policy will be appropriate for longer or a more restrictive policy may need to be considered."

"If labor market conditions were to deteriorate, with inflation stable or declining toward target and inflation expectations anchored at a level consistent with 2% inflation, policy could be eased further," he added. 

INFLATION RISKS

The risk that inflation will stall above 2% or move higher in the near term appear to have increased, Musalem said. Near-term inflation expectations have risen on expectations of higher tariffs, and such a move could be self-fulfilling, he said. 

A St. Louis Fed analysis finds that a 10% increase in the effective U.S. tariff rate, similar to what's been announced so far, could increase the PCE inflation rate by as much as 1.2 pp, of which 0.7 pp could contribute to more persistent underlying inflation through second-round effects on non-imported goods and services, Musalem said. 

"It could be appropriate to 'look through' direct effects of higher tariffs on the price level and at the same time 'lean against' indirect and second round effects," he said. "I would be especially vigilant about indirect, second-round effects on inflation. I would also be uncomfortable if medium- to longer term inflation expectations begin to rise." 

Positive demand conditions have been the main driver of solid payroll and wage growth so far, and the labor market remains healthy, but "I see the risks as skewed toward some further cooling of the labor market and inflation remaining above 2% or possibly rising in the near term," he said. 

Growth seems to have moderated in the first quarter as consumer spending weakened, reflecting bad weather and elevated economic uncertainty, Musalem said. Businesses also report acting with growing caution, adopting a wait-and-see posture rather than going forward with significant new hiring or fixed investment, he said. (See: MNI INTERVIEW: Tariff Inflation To Sideline Fed-Ex CEA Econ)