St. Louis Federal Reserve President Alberto Musalem cautioned that with inflation above the Fed's 2% target, policymakers cannot afford to tolerate higher price pressures while waiting for the potential benefits of strong productivity growth.
In prepared remarks for an event in Sao Paulo, Musalem stated, "In this context, it is critical that monetary policy remains substantially restrictive, rather than accepting slightly higher inflation today in pursuit of tomorrow's productivity gains." He added that a central bank's most significant contribution to long-term economic growth is providing a stable price environment, where businesses can plan investments and innovations that drive expansion.
Federal Reserve officials voted to hold interest rates steady at their July 28-29 meeting, though three policymakers dissented, favoring a rate increase. Other officials have signaled that the Fed may soon need to act to prevent high inflation from becoming entrenched, a risk they see as rising. Musalem, who does not have a vote on policy this year, indicated last week that he expressed a preference for a 25-basis-point rate hike at the previous meeting. He also noted that the subsequent selloff in Treasury markets underscores the importance of maintaining the Fed's credibility.
Productivity gains have been touted by some economists, including Fed Chair Kevin Warsh, as a potential outcome of AI that could ease long-term inflationary pressures. Warsh remarked after the July meeting that the timing of such effects remains uncertain. Musalem said on Thursday that restrictive monetary policy, which slows the economy, could also dampen innovation and hinder productivity growth. However, he cautioned that officials cannot take public trust in the Fed's ability to control inflation for granted. "If a central bank is perceived as tolerating above-target inflation with the promise of future productivity dividends, it could jeopardize anchoring," he said. "Once lost, credibility is costly to rebuild."
Policymakers are set to receive fresh labor market data on Friday and new inflation figures next week. During a Q&A session following the speech, Musalem noted that both supply shocks and AI-driven demand are contributing to higher inflation. He outlined two potential scenarios: one where inflation declines as tariff impacts fade and oil prices fall, and another where more persistent price pressures prevail, stabilizing inflation at 2.5% to 3% or higher. "In my view, the second scenario would require a slightly higher interest rate to address," he said.
Musalem stated he would closely monitor monthly inflation readings, looking for a pace slightly below 0.2% as evidence that inflation is moving toward the Fed's 2% target. He noted that inflation expectations remain anchored at a level consistent with that goal, but officials are highly sensitive to the risk of expectations becoming unanchored. The St. Louis Fed president also mentioned he is studying whether the Fed can ignore a series of supply shocks, and he warned that the effects of the El Niño phenomenon this fall could deliver another supply shock to the U.S. economy.
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