MNI INTERVIEW: Fed Strategy Shift Delays Price Progress-Koenig

The Federal Reserve appears to have adopted a more passive inflation-fighting strategy that could delay a return to its 2% target for several years more while prioritizing labor market stability, former senior policy adviser at the Federal Reserve Bank of Dallas Evan Koenig told MNI. 

The December rate cut and forecasts showing further easing over coming months are reminiscent of the "opportunistic approach to disinflation" charted by Alan Greenspan in the late 1990s, in which the Fed waited for external circumstances like a favorable supply shock or economic slowdown to lower inflation rather than take more aggressive measures, Koenig said in an interview. 

"It's as if the Fed had announced a target range of say 1.5% to 2.5%. As long as inflation is within that range, it’s close enough to where you want it to be, and we’re going to put more weight on labor market developments and risks than we would outside that range," he said. "That sounds like what this Fed is doing without acknowledging it explicitly." 

The implication of that approach is a longer road back to price stability, he said. "It may take longer than people are expecting, or at least policymakers are willing to acknowledge. Maybe we're talking three to five years from now." 

INFLATION RUNS HOT

With unemployment staying in a 4% to 4.5% range, growth strong and inflation above target, Taylor rules call for restrictive policy right now. Yet, the Fed cut three times last year in response to labor market risks, Koenig said. (See: MNI INTERVIEW: Fed Close To Done Cutting Rates, Says Harker)

Policymakers argue inflation risks have diminished as tariff effects work their way through the economy, but best estimates of inflation ex-tariffs still put price pressures above 2%. The Dallas Fed's trimmed mean measure, updated through September, strips out extreme price movements to measure underlying PCE inflation at 2.5%. 

"A major part of the Fed response seems to be that headline and core inflation are misleading right now as a result of tariffs. No doubt there’s some truth to that, but I don’t find that response entirely convincing," Koenig said. 

Nominal demand growth, which deteriorated briefly last year, rebounded to above 5% in the third quarter -- a level inconsistent with 2% inflation considering the FOMC estimates potential growth at 1.8%, Koenig said. 

Tack on to that the Atlanta Fed's latest estimate of real growth in the fourth quarter of 5.3%, and "there's every indication that going forward in the near term those nominal demand growth rates will stay far above what's consistent with a 2% inflation rate," he said. 

PRODUCTIVITY BOOST

While some policymakers point to pandemic-driven automation and AI as a productivity-boosting savior that would allow solid growth to continue without adding price pressures, Koenig remains skeptical, noting such trends are nearly impossible to confirm in real-time. (See: MNI POLICY: Fed Warms To Productivity Step-Up, Rethinks Risks)

"You’re counting on future good luck to close that final gap," he said. "If productivity growth drops again from these high rates to something more consistent with historical averages, then either people suddenly find the debt they'd taken on in anticipation of higher earnings growth and wage growth more difficult to service than they imagined -- or the Fed continues to support nominal demand growth, but you see increased inflation and you have to be prepared to abandon the 2% inflation objective. Neither of those are attractive outcomes."  

A politically-motivated push for lower rates without a corresponding drop in inflation risks creating financial instability similar to the late 1990s tech bubble, he said. 

“You can’t just say ‘trust us’ and that you’re committed to 2%,” Koenig said. “You have to act like you’re committed and explain the strategy for getting there.”