MNI INTERVIEW: Fed Needs To Signal Ready To Hike-Baumeister

The Federal Reserve needs to send a signal that it stands ready to raise interest rates if necessary, with heightened risks that inflation expectations could de-anchor, economics professor Christiane Baumeister told MNI.

"The Fed would be well advised to send a clear signal at this point," said Baumeister, an academic consultant to the Chicago Fed on finance who is also a former visiting scholar at other regional Fed banks, said in an interview. "Inflation expectations have already been on the rise. Consumer sentiment has been declining fast and hitting a record low, lower than in the financial crisis. All that doesn't bode well."

Inflation has been above the central bank's target for five years, and the most recent Fed projections showed officials do not expect it to reach 2% until 2028, said Baumeister. Consumer psychology has changed since inflation surged after Covid and expectations are at risk of de-anchoring again amid another adverse supply shock, this time from the Iran war, she said.

"I'm particularly concerned about the Fed's credibility at this point. The independence of the Fed has been on shaky grounds and that erodes trust," she said. "Then I think there's a real threat that inflation expectations could become unanchored. So in my view the only way out there is for the Fed to act decisively and send a clear signal that they are an inflation-fighter in that regard."

Final results of the May University of Michigan consumer survey showed year-ahead expectations jumping to 4.8% from 3.4% in February, prior to the commencement of conflict in the Middle East, while long-run inflation expectations climbed from 3.5% in April to 3.9% in May. A New York Fed survey showed year-ahead inflation expectations rising to 3.6%, though longer-term expectations have been unmoved. (See: MNI INTERVIEW: Fed's Next Rate Move Could Be A Hike-Haslag) 

INFLATION PSYCHOLOGY

With inflation expectations on the rise, the Fed doesn't have the luxury of waiting to determine whether demand destruction from higher prices will help loosen price pressures over time, said Baumeister, a professor at the University of Notre Dame. 

"Initial conditions are different than where we found ourselves before the inflation surge or the energy crisis in relation to the Ukrainian crisis, and so currently consumers are just more attentive to inflation, because they witnessed this recent surge, and so that means that they will be potentially more reactive and building in inflation into their expectation of future inflation increases."

Baumeister is skeptical that the war with Iran will come to a speedy and clean resolution. "In my assessment, there will be no quick resolution, and, even if we find a resolution, it will take quite a while to get back to something that we can call normal again, and I think it's going to be a new normal that looks very different from what we have seen before, at least when it comes to the oil market."

Determining in real time whether inflation expectations are de-anchoring can be difficult, she said. "You know it when you see it in a way, but you cannot see it until it's too late. That's my concern. So I don't want to wait."

"Demand destruction that they are counting on down the road - I mean it will happen - but I'm just afraid that it'd be too late, in the sense that inflation expectations by that time will have become unanchored," Baumeister said. "I see a real risk for revisions in medium-term inflation expectations down the road, and once the genie is out of the bottle it might be painful to get inflation expectations anchored again."