Fed Officials Flag Risk of Sticky Inflation

Federal Reserve officials said inflation is too high and may take time to cool, even as fresh price data came in hotter than expected and new research suggests the Fed may need to raise interest rates as far as 6.5 percent.

“The inflation readings are still not where we need them to be,” Cleveland Fed President Loretta Mester told Bloomberg News in an interview Friday in New York.

A U.S. government report showed a 5.4 percent increase in the Fed’s preferred gauge of price pressures in the 12 months through January. That was up from 5 percent the prior month and well above the Fed’s 2 percent target. Economists had expected an unchanged reading.

The report is “just consistent with the fact that the Fed needs to do a little more on our policy rate to make sure that inflation is moving back down,” Mester said.

Stocks fell on Wall Street, bond yields rose, and bets hardened on the Fed raising rates to a higher peak than previously thought as investors digested the risks of persistently high inflation—a threat that Fed Governor Philip Jefferson also flagged. “The ongoing imbalance between the supply and demand for labor, combined with the large share of labor costs in the services sector, suggests that high inflation may come down only slowly,” he told a conference in New York.

The inflation report and suggestions by policymakers that inflation may remain stubbornly high set the stage for Chair Jerome Powell’s semi-annual testimony on Capitol Hill on March 7. Powell will be tasked with explaining how he can get prices lower without tipping the economy into a recession and wrecking the best jobs market for American workers in decades.

“It is all leading to the March testimony, and he needs to have an answer about how they are getting through this—and it is not clear they do,” said Derek Tang, an economist at LH Meyer/Monetary Policy Analytics in Washington. “Part of the lower inflation story at least necessitates a slowdown if not a recession.”

Interest Rates Might Need to Reach 6.5% This Year

Both Jefferson and Mester were on a panel to discuss a new paper on the threats posed by the Fed’s aggressive moves to curb inflation, which was critical of its initial slow response to rising prices. The study, by a group of five prominent Wall Street economists and academics, said the central bank may need to raise rates as high as 6.5 percent to defeat inflation. “Our analysis casts doubt on the ability of the Fed to engineer a soft landing in which inflation returns to the 2 percent target by the end of 2025 without a mild recession,” they wrote.

The 55-page academic study included a series of simulations to predict likely paths for the Fed’s benchmark policy rates. The computer models suggested rates would peak at either 5.6 percent, 6 percent, or 6.5 percent in the second half of 2023.

Fed officials lifted their benchmark lending rate by a quarter of a percentage point at the start of February, bringing the target to a range of 4.5 percent to 4.75 percent. That was a step down from the half-percentage-point increase at their December meeting, which followed four consecutive jumbo-sized 75 basis point (bps) hikes.

Mester, who does not vote on monetary policy decisions this year, said last week that she saw a “compelling” economic case for rolling out another 50 bps rate hike at the meeting earlier this month.

She declined to say whether the latest PCE report nudged her toward favoring a half-point move when officials meet in March, but she stressed that the size of a move at any individual meeting matters less than the ultimate peak for rates.

“Where we’re going is more important than what we tactically do at any one meeting” she said, adding “ I don’t think we should prejudge.”

But she did note that the March meeting would be different because the Fed has already moderated the pace of its tightening action to 25 bps and “we have to take that as part of the environment we’re in.” In an earlier interview Friday with CNBC, Mester repeated her backing to get rates ‘somewhat’ above 5 percent this year and then stay there for a time.

Mester said on CNBC that her forecast in December for where interest rates would peak was “a little bit above” policymakers’ 5.1 percent median projection. She said her view hasn’t much changed since then. “I do think we need to be somewhat above 5 percent and hold there for a time in order to get inflation on that sustainable downward path to 2 percent,” she said.

Kicking off the conference’s afternoon session, Boston Fed chief Susan Collins made a similar point. “I anticipate further rate increases to reach a sufficiently restrictive level, and then holding there for some, perhaps extended, time,” Collins said in a prerecorded video address to the event. “Inflation remains too high, and recent data—including several strong labor market indicators, as well as faster-than-expected retail sales and producer price inflation—all reinforce my view that we have more work to do.”

U.S. monetary policy was also under fire at a separate New York event hosted by Columbia University, where St. Louis Fed chief James Bullard agreed that officials had hurt their credibility by initially arguing the 2021 surge in prices would prove temporary. But he said their subsequent robust action last year had helped repair the damage.

“Move quickly now, re-establish credibility now,” he told an audience which included a number of eminent economists including Stanford University’s John Taylor, author of the widely-used policy rule that carries his name. “Sometimes I use the phrase ‘more game theory, less econometrics,’” Bullard said.

—With assistance from Molly Smith & Steve Matthews.

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