MNI INTERVIEW: Iran Risks Tilt Toward Persistent- Ex-Fed Evans

Risks tilted toward a more drawn out Iran war should guide the Federal Reserve toward a neutral rate bias while staying on hold and monitoring how the U.S. economy evolves, former Chicago Fed President Charles Evans told MNI.

Supply chain disruptions tied to geopolitical tensions likely run deeper than appreciated, and the prospect that U.S. inflation may spend an extended period above 3% is real, Evans said in an interview on the sidelines of the Atlanta Fed's financial markets conference. Headline and core PCE inflation stood at 3.5% and 3.2%, respectively, in March. 

"The economy is in a pretty good place, but the risk assessment has deteriorated sharply," he said. "That gets at the supply issues, the oil issues, and ultimately the inflation question." 

It's not a replay of the post-pandemic inflation surge -- the key difference being the absence of acute labor market pressures that sent wages and prices sharply higher during economic recovery, he said. 

Nevertheless, "the imprint of this is likely going to be stronger and longer than originally thought," Evans said. "You have to worry that you're going to spend more time at 3-plus percent and not back down near two."

PRODUCTIVITY BOOM

This backdrop makes the case for resuming rate cuts a hard sell, said Evans.

"Two-sided risk for the next move seems about right. You can see why there were three dissents at the last meeting, and probably a lot of others who would have done the same if they were voting, or at least expressed sympathy with that viewpoint," he said. 

"The Fed is sitting at a place that is not unreasonable to stay on hold if they don't see the inflation progress they were expecting, and they're not seeing the labor fragility they were expecting either." 

If energy prices recede and underlying inflation truly is lower, new Fed Chair Kevin Warsh could then make the argument that policy is modestly restrictive and ought to adjust, Evans said. The new chair is also likely to point to productivity gains from AI to justify a lower rate path, though Evans is unconvinced by this argument. (See: MNI POLICY: Warsh Faces Resistance On Inflation, Productivity) 

The FOMC's long-run GDP growth estimate was revised up by two-tenths in March, a sign of optimism about the economy's underlying potential in light of already faster post-pandemic productivity growth. 

But as AI and related investment come into the picture, higher productivity tends to raise the marginal product of capital and push up the neutral rate, meaning the Fed would actually be more accommodative at any given setting, Evans noted. 

"It's hard to see the productivity argument really weighing in favor of a lower interest rate," he said. "You need a lot of assumptions."

FORWARD GUIDANCE

Warsh has been openly critical of forward guidance, but Evans said that while he appreciates policymakers' discomfort with putting out predictions, the Fed's experience shows guidance is most valuable when the policy rate is far from where it needs to be. 

Without some indication from the dot plot that more hikes were coming, the 25-basis-point increase in March 2022 might have been seen as woefully ineffective policy, after months of criticism that the Fed was behind the curve, he said.

Evans is skeptical that curtailing Fed utterances would reduce uncertainty. If anything, less official commentary risks leaving markets to fill the void, amplifying the signal from every data release and producing more volatility, he said.

"A lot of times you don't need forward guidance -- it's really meant to be an unusual instrument," he said. "But when you're far away from what you think is the appropriate funds rate, some kind of inclination that you're going to get there, but not all at once, is important."