St. Louis Fed President Alberto Musalem recently delivered a clear message: now is not the time for the Federal Reserve to consider cutting interest rates.
His core argument is that the Fed's real policy rate is currently "below neutral." The policy rate of around 3.6% might seem high, but when you subtract recent inflation—which ranges from 3.3% to 3.9% depending on the measure—the "real" rate is worryingly low. This real rate is likely below what economists call the 'neutral rate,' the theoretical level that neither stimulates nor restricts economic activity. If policy isn't restrictive enough, it won't succeed in bringing inflation back down to the 2% target.
So, what led to this hawkish warning? First, the latest inflation data is simply too high. Both the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE) price index re-accelerated to 3.8% in April. This resurgence wasn't a fluke; it was fueled by persistent shelter costs and a significant geopolitical shock. Tensions related to Iran drove Brent crude oil above $126 per barrel in late April, directly impacting the energy component of the inflation reports.
Second, people's expectations about future inflation are starting to drift higher. The University of Michigan's survey showed households now expect 3.9% inflation over the next five years. This is a critical signal for the Fed. If people believe high inflation is here to stay, they will demand higher wages, and businesses will raise prices, creating a difficult-to-break wage-price spiral. While other surveys are more stable, the risk of expectations becoming "un-anchored" from the 2% target is a major concern that justifies caution.
Third, the labor market is providing no reason to ease policy. The economy added a solid 115,000 jobs in April, with unemployment holding steady at 4.3%. This combination of positive but cooling job growth is often called a "soft landing" scenario. A stable job market means the Fed doesn't face pressure to cut rates to avert a recession, giving it the flexibility to maintain its focus on fighting inflation.
Musalem also cautioned against relying on future productivity gains from AI to solve the inflation problem. While AI may boost efficiency in the long run, its immediate impact is uncertain and cannot be a substitute for sound monetary policy today. Easing policy now based on a hope for future tech-driven disinflation would be a significant gamble.
In short, Musalem's comments, backed by hard data, signal a firm stance against premature easing. The Fed's path forward is biased towards holding rates steady, or even hiking them if inflation proves more stubborn. Any discussion of rate cuts is off the table until there is clear and convincing evidence that inflation is sustainably returning to the 2% target.
- Real Interest Rate: The interest rate after accounting for inflation. It is calculated as the nominal interest rate minus the inflation rate.
- Neutral Rate (r-star): The theoretical real interest rate at which monetary policy is neither expansionary nor contractionary, keeping the economy at full employment with stable inflation.
- Hawkish: A term describing a monetary policy stance that favors higher interest rates to control inflation, even at the cost of slower economic growth.