MNI INTERVIEW: Long Fed Pause Looms On Iran Shock - Sahm

The Federal Reserve is likely to keep interest rates on hold for some time, even if Kevin Warsh takes the helm of the central bank mid-year, because the Iran shock has accentuated risks to both inflation and unemployment, former Fed Board economist Claudia Sahm told MNI.

Warsh had been expected to push for lower interest rates given his dovish rhetoric in advance of the nomination, but Sahm believes current conditions will preclude any abrupt shift in policy.

“I suspect that we will end up with more continuity at the Fed because the economic backdrop is so uncertain that nobody would come in and rock the boat at a moment like this,” she said in an interview. “The Fed is very much in a waiting pattern. Warsh will understand that.”

Sahm said the Iran war’s hit to global energy supplies complicates the ability of the Fed to react because, despite a possible hit to economic growth down the line, the most immediate effect is at least a temporary spike in inflation. 

RESTARTING CLOCK

“We are going to get, and have already gotten, a burst of inflation from this,” she said. (See MNI INTERVIEW: Fed Will Hold Pat, Inflation To Spike-Benigno)

Before the war, the Fed appeared inclined to lower rates further later in the year, assuming that policymakers would be able to confirm that last year’s tariff increases had indeed had only a temporary impact on inflation. Now, there’s another new shock that needs to be waited out, one with a highly uncertain timeline and outcome. 

“They want to get us past the crest in the core goods inflation, because then that's a sign that, yes, those tariffs, those were one off price effects. But they want to see it, and then they will respond to it,” said Sahm. 

“There's definitely a question as to whether we're just going to restart the clock with that same kind of thinking on the energy shock? We're going to want to see evidence that it doesn't have the second round effects. So in terms of cuts driven by inflation, it's going to take some time.”

THIN BUFFER

Sahm thinks the economy was already softening before the war started. 

“It’s not just the energy shock itself, but also the backdrop that the consumer had already been under some pressure. While consumer spending has continued to grow, I think you could argue there had been some slowing in the pace as we went into this year,” she said. 

“We definitely see in the labor market wage growth has moderated. You might see some of this show through to slower consumer spending, bigger hits in disposable income.”

Sahm -- also a former White House economist and inventor of the Sahm rule that is used to predict recessions based on the unemployment rate trend -- does not see a full-blown downturn on the horizon but rather a muddling through, with perhaps some redistribution of growth toward the energy sector. 

If the economy were to falter, however, the Fed would not hesitate to support it, even if inflation were still fairly elevated, she added.  

“Are you really going to take the U.S. economy down over a percentage point of inflation?” she said. “If the unemployment rate starts to rise, or a series of contractions in employment payrolls, I feel like they will backstop the labor market.”