MNI INTERVIEW: Fed Can’t Ignore Mounting Price Pressures-Liang

The Federal Reserve needs to keep a close eye on inflation to ensure a recent uptick does not become more embedded in the price-setting behavior of businesses and consumers, former Fed economist Nellie Liang told MNI.

“The longer it goes on, the longer it gets ingrained, so I think there is some upside risk to inflation,” said Liang, also former Under Secretary of Treasury For Domestic Finance, in a new episode of The FedSpeak Podcast. 

“The Fed will need to be paying very close attention to this. The way they do this is by looking for evidence of how it might be changing price-setting behavior or wage-setting behavior, or if this is just a level shift, and the Fed should just look through it.” 

Liang cited mixed messages from measures of inflation expectations, which have resumed their ascent among consumers even over longer time horizons but remain fairly anchored according to market bets.  

TOO SOON TO TELL

“We're seeing higher inflation, we're not seeing inflation expectations from financial markets becoming unmoored, but consumers are starting to show signs of concern,” she said.

Against this backdrop, Liang said “it's too early to tell at this point” whether the central bank will hold rates for a prolonged period or choose to raise them. (See MNI INTERVIEW: Fed Needs To Signal Ready To Hike-Baumesiter) 

“Inflation has been above target for several years. It had been projected to reach its target over coming years, maybe in 2027 but this is clearly an interruption to that,” she said. 

Warsh’s focus on streamlined communications could lead to a more succinct policy statement, Liang added. 

BALANCE SHEET 

Liang said she expects the new Fed Chair Kevin Warsh to forge ahead with his plans to shrink the central bank’s balance sheet, primarily through efforts to implement changes to regulation and liquidity requirements that can reduce bank’s demand for reserves. 

She said that while a large balance sheet does not have obvious economic consequences, Warsh has made a persuasive case that the central bank’s large asset base does create political problems by confusing the roles of Treasury and the Fed and raising concerns about fiscal dominance. 

“Chair Warsh, consistent with his views on the balance sheet, thinks it's important to reemphasize the independence of the central bank to sort of clarify the separate lanes that Treasury and the Fed work in and are responsible for,” said Liang.  

FED TREASURY ACCORD 

That could be the aim of a new Fed-Treasury Accord that Warsh alluded to before his nomination. (See MNI: Warsh Wants Fed Out Of US Treasury's Business) 

“This is because the Fed has a bigger balance sheet and Treasury has more debt, and separating out responsibilities and authorities can be useful to clarify their shared objectives but clear boundaries, and I think that would be the goal of revisiting the accord.” 

Liang said recent reforms to the Treasury market including the implementation of central clearing and efforts to get more data on the repo market are improving resilience against market disruptions. But she added that the sheer size of the U.S. debt load limits the effectiveness of any particular reform effort. 

“Congress does need to get our fiscal position on a stronger trajectory. It is on an unsustainable path, and you can change the abilities of dealers to intermediate Treasuries, you can change the rules around how asset managers and hedge funds participate to provide liquidity in this market, but when there's a lot of debt, the potential for disruptions is just bigger,” she said.

Any reduction in the USD6.7 trillion balance sheet would likely be gradual and brought about through efforts to reduce the demand for reserves. 

“There's been quite a bit of work already floating around outside the Fed, and I assume inside the Fed, about different ways to bring down the balance sheet without causing disruptions in short-term funding markets, especially the repo market,” she said. “There's a bunch of supervisory tools that could be used encouraging banks to use the discount window when they need funding.”