Inflation is at risk of growing entrenched in the economy due to an overheated job market, and that will make it increasingly difficult for the Federal Reserve to bring inflation down without a recession, a central bank official said in an interview.
“I’m looking at a labor market that is so tight, I don’t know how you continue to bring this level of inflation down without having some real slowing, and maybe we even have contraction in the economy to get there,” said Kansas City Fed President Esther George, who is set to retire in January.
Some of Ms. George’s colleagues have recently said that they still see a way for the Fed to bring inflation down without a serious downturn, but Ms. George was more circumspect in an interview Tuesday.
“I would love if there was that path, and I’ve seen people paint that path,” she said. “I have not in my 40 years with the Fed seen a time of this kind of tightening that you didn’t get some painful outcomes.”
Officials are raising rates at the most aggressive pace since the early 1980s to combat inflation that is at a 40-year high. The Fed on Nov. 2 approved its fourth consecutive rate increase of 0.75 percentage point, raising the benchmark federal-funds rate to a range between 3.75% and 4%.
The Fed combats inflation by slowing the economy through tighter financial conditions—such as higher borrowing costs—that can curb demand.
The pandemic and disrupted supply chains were a major contributor to the initial surge in price pressures last year, said Ms. George. But she said the economy’s capacity to supply workers and produce goods and services—the so-called supply side of the economy—has been slower to heal, which has kept inflation at higher levels for longer than many policy makers anticipated.
The upshot is that the Fed will need to continue raising interest rates, even if it dials down the pace of increase at its Dec. 13-14 meeting, as many officials including Ms. George have supported.
“Seeing that we’re not going to get help in the supply side, we have a lot of work to do,” said Ms. George. “When I think about inflation today, we’ve kind of turned the tide of supply-chain, production-side shortages. Now, we’re really looking at labor as the driver here.”
Ms. George called recent reports of inflation decelerating a good start because they revealed prices for goods and services in interest-rate sensitive sectors of the economy, such as housing, were cooling.
But she said it was very premature to be looking ahead to when the Fed would stop raising rates because she was troubled by strong price pressures in labor-intensive service sectors. Those prices tend to be stickier, meaning they tend to slow very little or not at all outside of a recession.
Ms. George, who became president of the Kansas City Fed in 2011 and began her career as a bank examiner there in 1982, has been a leading voice for slowing down the pace of rate increases so that the central bank has more time to see how its policies are rippling through the economy over time.
At the same time, Ms. George has suggested that interest rates might have to rise to higher levels to slow the economy because households exited the pandemic in a better financial position thanks to government relief funds and deferred spending.
Ms. George said that it would make sense for the Fed to slow the pace of rate increases next year to a more traditional quarter-percentage-point increment. But she said “the real challenge” for policy makers centers on the dangers of prematurely ending rate rises.
“For me, the more important question for this committee, looking out over next year, is being careful not to stop too soon,” she said. “This was the lesson of the 1970s and ’80s, is thinking, ‘Oh, we’ve got it now, we can stop,’ and then you find that inflation really reemerges in some way.”
Markets rallied last week after the Labor Department reported that core prices, which exclude volatile food and energy items, rose 0.3% in October from September, the smallest monthly gain in a year. Core prices rose 6.3% in October from a year earlier, while overall prices rose 7.7%. Investors and policy makers watch core readings closely as a reflection of broad price pressures and as a predictor of future inflation.
Investors’ exuberance over better economic data could undermine the Fed’s efforts to maintain tighter financial conditions, which officials see as critical to their strategy of slowing economic activity. Ms. George said such behavior made it more important for the central bank to communicate clearly about its plans to hold rates at a higher level for longer.
She suggested officials could use their quarterly Summary of Economic Projections, or SEP, which includes policy makers’ individual interest-rate projections, at their next meeting to underscore their intention to raise rates higher and hold them at those levels for longer.
“It puts a premium on clear communication and being clear about your strategy, about where you’re going,” she said. “And of course, we’ll get some help, I’m guessing, with an SEP that’s coming at the next meeting…. And I hope that helps.”
Ms. George said it was too soon to say how her forecast of the peak or so-called terminal rate had evolved, but she said her own view had been on the “high end” relative to her colleagues given how persistent inflation has been.