Fed official says further rate cuts can wait

St. Louis Fed President Alberto Musalem said by the time of last month’s meeting the risk that inflation might get stuck between 2.5% and 3% had increased. As a result, he thought greater caution would be appropriate in making further reductions.

Musalem had previously indicated he was supportive of the Fed’s decision to begin cutting rates with a bolder half-point rate cut in September. “Since September, the picture changed," he said in an interview at the bank on Thursday. “The economic data came in stronger…and the inflation numbers printed higher than desired. So I changed my assessment of risks."

Going forward, rate reductions “have to be gradual—and more gradual than I thought in September," he said.

Musalem, an economist who spent much of his career in finance, joined the bank last April and will take a turn as a Fed voter this year. He said he wasn’t one of four officials last month who suggested a rate cut wasn’t needed in projections submitted at the meeting. He said he penciled in two cuts for this year in those projections, putting him in line with the median of 19 participants who submitted them.

Among the puzzles facing Musalem and his colleagues this year is what constitutes a “normal" or neutral interest rate that neither spurs nor slows growth. That question hadn’t been relevant for most of last year because the Fed had lifted rates to a two-decade high to combat high inflation.

But with inflation declining and worries mounting about weaker labor-market conditions last summer, the Fed began lowering rates. Officials cut rates at each of their last three meetings by a combined percentage point. Fed officials have broadly signaled they are inclined to hold rates steady at their next meeting, scheduled for Jan. 28-29.

Musalem said the labor market is in good shape and needs to be watched carefully, but the part of the Fed’s mandate that is “still out of bounds is on the inflation side."

Musalem said that because his estimate of the neutral rate is slightly higher than most of his colleagues’, the current setting of interest rates might be slightly less restrictive than would be appropriate.

He said it was too soon to say how the Fed might need to adjust its interest-rate stance if the incoming Trump administration follows through with threats to impose broad new tariffs that send up the price of consumer goods and services. The “textbook response" would call for not changing the Fed’s policy outlook if prices rise in a one-off fashion, Musalem said, but it is far from clear how any tariffs will be rolled out.

“Will it be a ‘one-and-done’ or will it be two years of a sequence of tariffs in many different sectors of the economy?" he said. “If it’s over two years, incrementally, every month or every two months, it gets harder to parse out."

Fed officials are uneasy because they believe consumers’ and businesses’ expectations of future inflation can be self-fulfilling. After several years of high inflation triggered by the pandemic and a policy response that showered the economy with ultralow interest rates and fiscal stimulus, it is harder to predict how a new round of price hikes could influence expectations.

“It’s a $30 trillion economy. It’s very complex. It’s not a textbook," said Musalem. “We’re going to have to wait and see what is implemented, how it’s implemented, what’s the size, what’s the duration, what are the interactions with other countries."

Long-term interest rates have climbed notably in the months since the Fed’s first cut, with yields on the 10-year Treasury note recently near their highest level in a year. But Musalem said he thinks financial conditions, which include borrowing costs and asset prices, are still supporting economic activity.

Musalem said higher long-term interest rates over the past four months mostly reflect an increase in “real" or inflation-adjusted yields, meaning they don’t reflect expectations of higher inflation by investors.

“That’s not to say that inflation expectations didn’t rise a little bit. They did. But I think 70% of the move has been the real rate," Musalem said. Higher real rates, in turn, mostly reflect an increase in what’s known as the “term premium" or the extra yield that investors demand for the risk of buying longer-dated securities, he said.

Musalem said the rise in long-term rates had unfolded in two phases: First, the Fed’s bolder half-point cut in September and subsequent economic data dashed fears of a recession that had percolated in financial markets.

Second, the outcome of the U.S. election further contributed to changes in long-term rates by leading investors to rethink the outlook for growth. Higher real yields can reflect a more optimistic economic backdrop or greater uncertainty about the future.

“The interpretation could be, ‘The future’s more uncertain, and we need more premium for that,’ " said Musalem.