Fed's Musalem Says He Expects Warsh Will Consult, Try and Steer FOMC

Tom Keene

The US has inflation above target, long-run inflation expectations creeping higher, and a real policy rate below the FOMC's neutral estimate, suggesting no restraining force on the economy.

Alberto Musalem

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

Tom Keene

Given the risks on both demand and supply sides, it sounds like Musalem thinks the Fed should lean towards tightening, possibly supporting removing the easing bias at the April meeting.

Alberto Musalem

There are two scenarios: 1) Inflation remains high with no disinflation, requiring a hike. 2) Economy weakens materially, inflation comes down, leading to no hikes or even cuts.

Tom Keene

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

Alberto Musalem

I don't comment on market pricing. Markets have repriced on the front end as they try to understand our reaction function.

Tom Keene

Musalem warns policymakers cannot depend on a potential AI productivity boom to ease inflation in the short term. The buildout of data centers is putting upward pressure on inflation.

Alberto Musalem

I am an AI enthusiast and productivity optimist, but productivity is at or below the long-term average. Relying on productivity to do the inflation job is risky. AI currently adds demand pressure through chip prices and construction for data centers.

Tom Keene

Some, like John Williams, emphasize disinflationary forces from AI (job losses). Musalem seems clear that upside pressures from AI demand are the larger factor in the next year.

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, which we don't see yet.

Tom Keene

Since the Iran crisis, bond yields have risen, largely due to an increase in the term premium and inflation expectations. Has the bond market already done some of the Fed's work?

Alberto Musalem

My decomposition differs: about three-quarters of the move in bond yields is due to an increase in the expected neutral policy rate, and one-quarter due to higher term premium. Forward real rates have risen meaningfully.

Tom Keene

Does the tightening in the bond market make the incoming Fed Chair Kevin Walsh's job easier? Or must he still focus on the short-term rate?

Alberto Musalem

Chair Walsh will look at the economy and exchange views on the best policy. He has been sworn in and will have his first meeting in two weeks.

Tom Keene

Walsh wants to reduce forward guidance, public speeches, and the dot plot. Many have tried this before and later wanted to communicate more. Will he have a similar learning curve?

Alberto Musalem

Walsh has been at the Fed before, so his learning curve will be lower. He will consult with the full committee. It's healthy to review communications policy and the monetary policy framework.

Tom Keene

Musalem wanted to 'connect the dots' to make forecasts more meaningful, while Walsh wants to eliminate them. This is a straightforward disagreement.

Alberto Musalem

I favor a communications policy that effectively transmits our reaction function. The dots can be made more effective by connecting them, or replaced with something else that is effective.

Tom Keene

Walsh wants to shrink the Fed's balance sheet. Governor Barr said that would raise financial stability risks. What does Musalem think?

Alberto Musalem

This needs to be studied. Reducing the balance sheet from the supply side could be disruptive. Reducing it from the demand side (by reducing banks' demand for reserves) would be smoother.

Tom Keene

Does Musalem share the desire for a smaller balance sheet?

Alberto Musalem

There are benefits to a large balance sheet for financial stability, but it's also healthy to have the minimum balance sheet needed to operate monetary policy and promote stability. We need to find that level.

Tom Keene

People question why the Fed would raise rates when it can't affect global energy prices or the AI rollout. What is the rationale?

Alberto Musalem

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

Tom Keene

Walsh has talked about being an agent of change, breaking heads, and having a revolution at the Fed. Has he presented himself that way internally?

Alberto Musalem

Chair Walsh will ask profound and deep questions about how we operate monetary policy, communications, and operations. That is refreshing. A new leader should come in with a vision and ask deep questions.

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