MNI INTERVIEW: Oil Shock Requires Vigilant Fed - Mester

The Federal Reserve faces an inflation problem beyond that caused by tariffs and the oil shock and risks moving too quickly to resume rate cuts without sufficient evidence that price pressures are headed durably lower, former Cleveland Fed President Loretta Mester told MNI.

In an interview on the sidelines of the Semafor World Economy conference in Washington, Mester said the FOMC is right to keep interest rates on hold as geopolitical tensions cloud the outlook, warning that inflation risks remain tilted to the upside even as markets lean toward a more benign scenario.

"We never got back down to 2%," Mester said. "The inflationary pressures that were supporting a 2.5, 2.6, 2.7% reading are still in the economy -- and now they're being exacerbated by the oil price shock."

An end to the Iran war could allow conditions to normalize by late this year or early next, but the range of outcomes remains unusually wide and include much more adverse scenarios, Mester said. 

The right posture for the Fed is vigilance and patience, to hold rates and preserve the optionality to tighten if necessary, she said.

"If they have to react by raising at some point -- and they're not there yet, and I don't think they should be doing that at this point -- but they need to be making sure that people understand they are going to be taking inflation back to price stability."  

UNEASY BALANCE

Mester, who retired from the Cleveland Fed in 2024, worries the FOMC could ease too soon due to labor market softness rather than clear progress on inflation. The oil shock simultaneously threatens growth and keeps inflation elevated, a classic stagflationary dilemma.

"Probably the reason for the next move will be because of labor market concerns, not because of sufficient evidence that inflation is on a downward path," she said. "I have some concern they may be a little too quick to pivot to rate cuts again." 

The job market already exists in what she calls an "uneasy balance" with a much lower pace of job creation in recent months than has been usual, she said. 

Reduced immigration has tightened the labor supply, meaning firms that have held back on hiring amid broad uncertainty were able to do so without unemployment rising meaningfully, she said. 

“If we could get beyond the uncertainty, there is a possibility that things will pick up,” she said, cautioning that a return to the labor market dynamics of previous years is still unlikely given aging demographics. (See: MNI INTERVIEW: US Jobs Market In Fragile Equilibrium - Sahin)

FRAGILE INFLATION EXPECTATIONS

A pressing concern is that the oil shock is landing on an inflation backdrop that never fully normalized, leaving inflation expectations more fragile than they appear, Mester said.

"When we went through the post-COVID inflation surge, it was short-run expectations that jumped while medium- and long-run stayed stable," she said. "But that stability wasn't sufficient to avoid high inflation. It's a necessary condition but not a sufficient one."

Already core price pressures were proving stubborn before the war, partly due to tariffs but also on climbing health care and insurance costs. Many firms were attempting to protect margins by raising prices but have met consumer resistance.

That dynamic could shift if elevated inflation persists, Mester said. 

"If customers begin to see prices staying up at these levels, I think they're going to be more willing to accept those higher prices -- and that could support inflation remaining higher."

The Fed would need to see inflation clearly moving upward, not merely staying elevated, to consider rate hikes, Mester said. Current conditions do not meet that bar, but once that threshold is crossed, a single move would likely be insufficient. 

"If inflation really is moving up, it's reasonable that it's going to be more than one."