Fed's Alberto Musalem Talks Fed Policy

The US has inflation running meaningfully above target, long-run inflation expectations creeping higher, and a real policy rate below the neutral level, which together sound like someone who wants to raise interest rates.

Stephanie Flanders

Alberto Musalem

The real policy rate is around 0.5%, below the committee's 1% neutral rate. Policy is at or slightly below neutral. The balance of risks has shifted towards inflation and away from employment.

I supported the interest rate decision but thought the easing bias was no longer consistent with the outlook.

Alberto Musalem

There are two scenarios: one where inflation remains high and a hike is required, and another where the economy weakens materially, allowing for no hikes or even a cut.

In the second scenario, real incomes and corporate margins are challenged, bringing inflation down.

Markets are pricing a rate hike by March 2027. Is that sensible given oil prices and supply-side risks?

Stephanie Flanders

Alberto Musalem

I don't comment on market pricing. Markets have repriced to understand our reaction function.

You warned policymakers cannot depend on an AI productivity boom to ease inflation in the short term, and that AI data center buildout is putting upward pressure on inflation.

Stephanie Flanders

Alberto Musalem

I am an AI enthusiast and productivity optimist, but productivity is at or below the long-term average. Relying on it for disinflation is risky. AI is currently a demand story, not a supply story, putting upward pressure through chip prices and construction.

In my district, construction companies are shipping specialized workers across the country to build data centers. This is visible in aggregate demand and capex numbers.

You seem clear that the upside demand pressures from AI will be the larger factor in the next year, versus disinflationary forces from job losses.

Stephanie Flanders

Alberto Musalem

In the short run, demand pressures from AI are more prominent than supply relief. I will change my view when I see AI contributing to aggregate productivity growth.

If productivity growth is expected to be permanent, it puts upward pressure on real interest rates. If transitory, the supply side wins and puts downward pressure.

Has the bond market already done some of the Fed's work by tightening financial conditions through higher term premiums?

Stephanie Flanders

Alberto Musalem

My interpretation is different: about 3/4 of the move in bond yields is due to an increase in the expected neutral policy rate, and only 1/4 to higher term premiums.

Forward real interest rates have come up meaningfully in the last month or two.

Incoming Fed Chair Kevin Warsh wants to reduce forward guidance, public speeches, and the dot plot. Do you think he will have a learning curve?

Stephanie Flanders

Alberto Musalem

He has been in the Fed before, so his learning curve will be lower. I expect him to consult with the full committee. It is healthy to review communications policy.

You wanted to connect the dots to make them more effective, while Warsh wants to eliminate them. That is a straightforward disagreement.

Stephanie Flanders

Alberto Musalem

I favor a communications policy that effectively transmits our reaction function. We can make the dots more effective by connecting them, or replace them with something else that is effective.

Governor Michael Barr said shrinking the balance sheet would raise financial stability risks. What do you make of that?

Stephanie Flanders

Alberto Musalem

Reducing the balance sheet from the supply side could be disruptive. Reducing demand for reserves from the banking system would be a smoother path.

There are benefits to a large balance sheet for financial stability, but the central bank should have the minimum balance sheet needed to operate its framework.

Why raise interest rates when the Fed cannot affect global energy prices or the rollout of AI?

Stephanie Flanders

Alberto Musalem

Our mandate is price stability and maximum employment. We are above target on inflation, the economy is robust, and the labor market is at its natural rate. The probability of a rate hike in the future has to be greater than zero.

Inflation expectations are drifting higher. We are missing on one side of the mandate and not on the other.

Kevin Warsh has talked about being an agent of change. Has he presented himself that way internally?

Stephanie Flanders

Alberto Musalem

He will ask profound questions about how we operate. A new leader should come in with a vision and ask deep questions about past practices. I find that refreshing.

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