St. Louis Federal Reserve President Alberto Musalem is worried that easing financial conditions could boost demand, complicating efforts to combat inflation. A senior Federal Reserve official suggested that after the unusual 50 basis point rate cut earlier this month, the Fed should return to a "gradual" rate reduction approach.
Musalem noted that the U.S. economy might respond "very strongly" to looser financial conditions, potentially extending the time required to achieve the 2% inflation target. He mentioned that rate cuts at this stage are seen as gradually easing economic restrictions.
Musalem, who became the St. Louis Fed President in April and will join the Federal Open Market Committee (FOMC) as a voting member next year, highlighted that the Fed had abandoned the traditional 25 basis point cut in favor of a 50 basis point reduction, the first such move since the onset of the COVID-19 pandemic.
This significant rate cut keeps the federal funds rate between 4.75% and 5%. Fed Chair Jerome Powell stated that the goal was to maintain the strength of the world's largest economy while preventing a weak labor market amidst falling inflation.
Last Friday, the Fed's preferred inflation measure, the PCE annual rate for August, dropped to 2.2%, a larger-than-expected decline. Following the data release, interest rate futures traders saw a slightly higher probability of a 50 basis point rate cut in November compared to a 25 basis point reduction.
Musalem supported the significant rate cut in September, acknowledging the recent cooling of the labor market, but remained optimistic about the economic outlook due to low layoff rates and underlying economic strength. He remarked that the business sector is in a "good position" with "stable" activity overall, suggesting that large-scale layoffs are not imminent.
However, he admitted that the Fed faces risks that might prompt faster rate cuts. He noted that if economic weakness exceeds current expectations, a quicker pace of rate reductions could be appropriate.
This view aligns with recent comments from Fed Governor Waller, who expressed willingness for more aggressive rate cuts if data weakens faster. Musalem emphasized that the risks of economic slowdown and rapid growth are now balanced, with future rate decisions depending on the data available at that time.
The Fed's latest "dot plot" indicates that most officials expect another 50 basis point cut during the two remaining meetings this year, with the next meeting scheduled for November 6, a day after the U.S. Presidential election. However, opinions among officials vary, with some suggesting delaying additional rate cuts and others predicting only a 25 basis point cut this year. Policymakers also anticipate a 100 basis point reduction in policy rates by 2025, with rates hovering between 3.25% and 3.5% by the end of that year and slightly below 3% by the end of 2026.
Addressing claims that the September 50 basis point rate cut was a "catch-up" move due to slow Fed action in easing monetary policy, Musalem refuted this, noting that inflation has been declining faster than anticipated. He stressed that the sharp rate cut sends a clear signal that the economy is starting from a very favorable position.
