MNI INTERVIEW: Fed Has Little Room to Look Past Iran Inflation

The Federal Reserve has forfeited the flexibility to look through the inflationary shock from the Iran war after having never fully restored price stability post-Covid, and will be forced to raise rates if inflation moves meaningfully higher, Joe Tracy, a former senior adviser to the Dallas Fed president, told MNI.

Had the Fed pursued more decisively its 2% inflation target earlier, it would now have the optionality to treat the surge in oil prices as a temporary supply shock, Tracy said. Instead, with inflation above target for six years running, the Fed may have to respond more aggressively to any further uptick in core measures. 

"They can't wait," Tracy said in an interview. "If inflation starts to move up reasonably, I think they're going to have to raise rates and basically follow a Taylor rule and make sure that their real policy rate is rising."

The central bank's credibility is too fragile to risk another episode of apparent passivity, Tracy said, adding that inflation expectations remain anchored "until they're not" -- and that by the time policymakers notice the change, it may be too late. 

"The last thing the Fed can allow to happen is for inflation expectations to shift up," he said. "Then you can be sure they're going to have to be much more aggressive. Think back to Volcker -- they certainly want to avoid that."

SELF-INFLICTED CONSTRAINT

A sustained move higher of 30 to 50 basis points by any of the core inflation measures would force the Fed's hand, Tracy said, adding that President Donald Trump's nominee for Fed chair, Kevin Warsh, is unlikely to yield to pressure from the administration to cut rates either.

The Fed's dilemma is partly of its own making, said Tracy, now nonresident senior fellow at the American Enterprise Institute. By opting for a cautious approach to avoid recession, policymakers left themselves exposed to precisely the kind of external shock they now face. 

"Instead of achieving a soft landing, they achieved no landing," he said. "They ran out of time, this event happened, and they would have been in a much better situation had they more decisively dealt with the inflation issue a couple years ago."

Financial conditions have tightened as market expectations shift from pricing in two quarter-point cuts this year to roughly even odds of a rate increase, and term premiums are rising to reflect the wider range of uncertainty around the conflict's duration, resolution and ultimate impact on energy prices, Tracy said.

Still, conditions remain easy, an indication that Fed rates are near neutral, Tracy said. 

"The question is, given where inflation was and still is, is that the appropriate policy?" he said. (See MNI INTERVIEW: Prolonged Fed Hold On Stagflation Risk-Lavorgna)