MNI INTERVIEW: Prolonged Fed Hold On Stagflation Risk-Lavorgna

The Federal Reserve will likely need to leave interest rates on hold this year as stagflationary pressures associated with the war in Iran raise risks to both sides of the central bank’s mandate, former Counselor to the U.S. Treasury Joseph Lavorgna told MNI. 

Lavorgna said the economy was poised for a bumper 2026 until the Iran shock raised oil prices to levels that are set to both boost inflation and dampen the boost to GDP from tax cuts and deregulation. 

“When in doubt, they’re going to sit it out. The Fed is going to wait and not do anything,” said Lavorgna, chief economist at SMBC Americas, who left the Treasury earlier this year.

“Tariffs you can look through. It’s harder to look through energy costs because they’re an input, it’s potentially not a one-time price effect. So you have to be very careful trying to offset the demand shock from the higher prices not knowing how long prices are going to persist.” 

Before the war, the Fed appeared set to keep cutting rates gradually because it was willing to look through some lingering inflation that it attributes largely to the temporary effect of tariff increases. That meant that strong growth was likely to help stabilize a job market that has clearly softened, Lavorgna said in an interview. 

“Now with what’s happening with the energy markets that's been cast in doubt, because the energy price of particularly retail gas is a huge cash strain on U.S. households,” he said. (See MNI INTERVIEW: Fed On Pause Amid Two-Sided Risks - Rosengren)

STAGFLATION WITH A SMALL S

In a scenario where the war and the associated spike in energy costs drags into summer or fall, it’s plausible that economic growth slows to around 1% even as inflation jumps to 4% from current readings close to 3%, Lavorgna said.

"That's stagflation with a small 's'," he said, adding that this doesn't yet compare with the 1970s equivalent but carries its echoes. 

That would force the Fed to stand pat – though not hike rates – because, by its own admission, rates are still mildly restrictive as it is and financial conditions are already tightening further because of the energy shock, said Lavorgna, who was previously chief economist at the White House’s National Economic Council. 

“To me standing pat is enough.  I think it's going to be very difficult for the Fed to hike rates, because, number one, by the Fed's own admission, rates are above neutral, wherever that is. Number two, if this situation persists, and that means financial conditions are going to be tighter because you're going to have higher yields, you have a stronger dollar, you're going to have weaker equity prices. The uncertainty around the outcome is going to cause companies to be more cautious.” (See MNI INTERVIEW: Fed Hike Still Unlikely Base Case-Lockhart) 

The Fed cut rates three times last year to a 3.50-3.75% range, but Lavorgna noted the spike in bond yields since then has all but erased any easing of monetary conditions, with the 10-year Treasury yield trading at 4.37% Thursday.