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We consider the path forward for this conflict and of course, ultimately what it means for the global economy. That is a challenge that policymakers have to deal with not just on Capitol Hill, but inside the Federal Reserve Building, in the various buildings across the country that the FED inhabits, as they consider the economic picture, in the inflation picture
that this has created. And it's on that note we turn now to the Rekuvic Economic Conference, where the Saint Louis FED President ALBERTA Muslim is sitting down with Bloomberg's very own Stephanie Flanders. Let's go live now to Iceland.
Well, thank you so much. I am indeed here in Rekievik with Alberto Musalem. Thank you very much for joining us. In your speech here at this conference, you pointed out that the US has inflation running meaningfully above target, long run inflation expectations creeping higher, and yet a real policy rate that was below the level that the Federal Open Market Committee think is neutral, so not actually applying any
restraining force on the economy. All those things together sound like someone who wants to raise interest rates crazy to be with you.
That's right.
The real policy rate right now is running at around half a percent, which is lower than the one percent that the Committee believes is the neutral rate. I think you have to look at the full picture, and it looks to me like policy is at or slightly below the committee's long run neutral level.
But if you combine that with the other things you talk about, you had emphasized the risks of the inflationary pressures on the demand side and the supply side of the economy. It it sounds like you think they should be leaning towards tightening. It sounds like you probably you might have been one of the policy makers in the April meeting who actually thought they should have removed the statement against tightening in the statement.
So yeah, I supported the interest rate decision, but I thought the easing bias was no longer consistent with the outlook and the balance of risks, which in my mind, the bouncer's risk has shifted a little bit towards the inflation side, unless towards the employment side.
So whether the.
Economy will require a hike or a cut or hold will depend on the scenario. There is a scenario where inflation remains high, there's no disinflation in the next quarter or two, and in that scenario, the economy will probably require a hike. There's also a scenario where the economy weakens materially in the second half of the year because real incomes are challenged and corporate margins are challenged. In
that scenario, inflation could come down. In that scenario, we would be thinking of no hikes, maybe even a cut. So there are two scenarios to play with here.
But looking down the track, at least the markets are now fully pricing a rate hike by March twenty twenty seven. Given where we are now, how we think things are going to proceed with oil prices and some of the risks on the supply side that you talk about, do you think that's a sensible thing for them to.
Price again, I think there are two scenarios here, and I don't comment nor with on market pricing. I'm more focused on what's best for the economy and from main street markets, every price materially in the US and in other countries, and the front end of the curve, I think that's markets trying to understand what our reaction function is.
So I'm going to quit here because in your speech you talk very directly about the impact of AI on productivity and the long run impact that could have on monetary policy and on interest rates, But you warn that policy makers cannot depend on a potential productivity boom from artificial intelligence to ease elevated inflation right now in the short term, and in fact, you seem to suggest that the buildout of all the data centers associated with AI
was actually putting upward pressure on inflation. Do you think the incoming FED chairman Kevin Walsh is one of those policy makers that's inclined to be hoping for that.
So I'll speak about my views.
I am an AI enthusiast and productivity optimist, but at present it's unclear that productivity, first of all, is higher than the long term average, is actually at or below the long term average, And so to rely on productivity to do the inflation job seems a risky proposition because what if the productivity doesn't materialize in the future, we could end up with higher inflation today and in the future. And what AI is doing right now, it is not
really expanding the supply side of the economy. Yet what it's doing is is putting upward demand pressures. You know, through chip prices for the build out in my district, I hear of construction companies shipping workers all over the country. It is specialized trades persons to bill out the data centers.
So at present, it's more of a demand story from AI than a supply story, and you see that in the AGGRI demand numbers, and the percentage of CAPEX that is coming from the AI build out is material.
But of course a lot of this does come down to how you think in the scenario the next sort of year and a half, that that's what you're focused on when you think about where the policy is right now and in the next few quarters. There's obviously different pressures right There's some have emphasized, even John Williams has talked about the disinflationary forces that come from AI. If you start to see people lose their jobs, if you
see jobs eliminated as AI is rolled out. You've highlighted more of the supply side, the sort of upside pressures that come from data centers and other things, those kind of pressures on resources. You seem pretty clear that those upside pressures are going to be the larger factor at least coming from the AI revolution in the next year.
I think there are two things. In the short run.
I think the demand pressures are more prominent than the supply relief. I'm prepared to change my view if and when I see AI actually contributing to agrig productivity growth, which we don't see just yet in the data, and when that becomes evident that that's actually putting downward pressure on inflation. At present, that's not where we are now in terms of the long run productivity and AI.
If and when we get.
Productivity to grow above its long run average where it currently right now is not. The impact on real interest rates will depend on how permanent that increase in productivity growth is expected to be. If it's expected to be very permanent, that will put upward pressure on real interest rates. If it's expected to be transitory, then the supply side will win and that will put downward pressure on interest rates.
One other thing that's happened since the beginning of the Iron Crisis is a real change in bond yields, and actually, we certainly think of Bloomberg economics, we think that's been largely due to an increase in the term premium slightly an increase in what we're expecting on inflation, but mainly on the term premium. So in that sense, has that the bond market already done some of the Fed's work
for it? I mean, is that producing a meaningful tightening even though you have a very low short term rate.
So my interpretation of what's happened to bond markets is that they're seeing an economy that's resilient on the real side, they see a labor market that's been resilient on the real side. They see higher realized inflation, they see higher expected inflation. When I look at the decomposition, I arrive at a different conclusion than your team, which is a fantastic team. My understanding, it's about three quarters of it was an increase in the expected neutral rate policy rate,
that is in about one quarter higher term premia. Now, if you look at forward markets.
So just on that, you don't think it is hasn't meaningfully tightened financial conditions if you're looking on that kind of medium term.
So I was about to say, if you look at the forward real interest rates, Marcus have raised the real implied forward so they real interest rate a year from now, they're real interest rate two years from now have come up meaningfully in the last month or two.
But just going back to the things, you don't think that it's made that the incoming Kevin Walsh is not. His job hasn't been made any easier by the tightening in the bond market. You still you would still have to be focused on that short term rate.
I think when he comes in, he's going to take a look at the Oh he has come in, he's been sworn in. You know, he's gonna he's gonna have his first meeting next the next two weeks, and he's going to have to look at the economy, and we're all gonna have to look at the economy and you know, exchange views on the economy and exchange views on what the best policy for the American people is at that point in time.
Well, the other thing that the incoming FED chair has talked a lot about is changing the Fed's communication tools. He said he doesn't want to see so much or indeed any forward guidance. He wants to have fewer public speeches, he wants to get rid of the dot plot. Lots of people come in saying they want to have less less forward guidance and then they find they want to say things to the markets. Do you think that he's going to have a similar kind of learning curve.
Well, he's been in the FED before, so his learning curve will probably be much lower than somebody who had not been there before. You know, he's expressed some views during the last year or so. Once he's in the seat, once he consults with the full committee, and I expect him to consult with the full Committee and all these matters, you know he will he will try and steer the committee in a direction or another.
And I think it's always.
Healthy to look at your communications policy, your monetary policy framework and see how to adjust each or both to make sure we're fulfilling the dual mandage as best we can.
But you're kind of on the opposite side of this, because you wanted to actually connect the dots to the whole forecast, not review whose dots they were, but make a bit more sense of what the dots represented the bigger picture, whereas he, instead of elaborating on the dots, he wants to get rid of them all together. I mean, that's just a straightforward disagreement.
Well, I would say what I think I would like the most favor of the most is that we have a communications policy that is very effective at transmitting what our reaction function is at any point in time. Right now we have the dots. We can make the dots more effective by connecting the dots in terms of transmitting
our reaction function. Now you could also think of not having the dots, but replacing them with something else that is effective in transmitting to the markets and households and businesses what our reaction function is.
The other big thing that certainly people in the financial markets have been very focused on in Kevin Walsh's comments is about wanting to shrink the fed's balance sheet, And actually Governor Michael Barr said just the other day that he thought that was just the wrong goal, that it would actually raise risk for financial stability, and that it wouldn't necessarily reduce the footprint in financial markets.
What do you make of that.
I think that's something that needs to be studied and we need to all review what the options are for doing that if we so desired. And I think it's very different to reduce the balance sheet from the supply side, which could be very disruptive, or reduce the balance sheet from the demand side for reserves. Demand for reserves are
supposed to apply for reserves. If we went in the direction of taking measures that would reduced the banking system's demand for reserves, then that would be I think a smoother path towards a lower balance sheet and percenta GDP or a lower growth of the balance sheet in nominal terms than simply reducing supply, which could be disruptive.
But other things equal, do you do you kind of share the desire on balance to have a smaller balance sheet.
I think I'm going to do a two handed economists. Now, there are some benefits having a large balance in terms of financial stability, but it's also I think healthy for the Central Bank to have the minimal or minimum balancee that it needs to have to operate its monetary framework and to promote financial stability. Now, so I think we need to understand that where that is.
Just a last question when you talk about communications, and we've certainly had a lot of communications about the FED from the White House, but also we have ordinary people who are coping with the impact of higher gasoline prices. We're definitely having a conversation about higher interest rates now that we wouldn't have expected to have six months ago.
And I think a lot of people, whether in the White House or in the broader economy, would say, hang on, what is the Fed doing thinking about raising interest rates in an environment where it can't affect the global energy price that's the thing pushing up inflation, and it definitely can't affect the rollout of AI because that seems to be just an unstoppable force.
So why raise.
Interest So our mandate is price stability and maximum employment. And right now we're above target on inflation, and so the possibility or probability that we might consider and interest rate increase in the future I think has to be
greater than zero. You know, the economy has been robust, GDP growth has been at or around potential, The lave market is right around in terms of unemployment, right around its natural rate around four point three four point four, And so we're missing on one side of the mandate. Inflation expectations are drifting higher to some degree, and we're
not missing on the other side of the mandate. So you have to take all all the factors, and you know, we have a statutory responsibility to hit both sides of the mandate.
And finally you did mention. Kevin Walsh was sort of as in the building and has been sworn in. He talked in the past about wanting to shake break, break some heads and have a sort of revolution, be an agent of change in the FED. Is that the way that he's presented himself Internally?
I think the new chair or Chair Warsh i should say, will be asking some very profound and deep questions about many ways in which we operate monetary policy, communications operations, and so I think that's refreshing. You know, a new leader should always come in with a vision and asking very deep questions about how things were done in the past.
I expect that to be the case. All A bet Massalam.
Thank you very much for joining us, and I think we'll even forgive you for disagreeing with our US economics team.
Thanks very much,