St. Louis Federal Reserve President Alberto Musalem said high oil prices are likely to leave core inflation near 3% for the rest of the year, keeping inflation a noticeable distance above the Fed's 2% objective and reducing the case for an imminent cut in interest rates.
In a Reuters interview, Musalem warned that "It's likely we're going to see some pass-through of oil prices onto core inflation," and that the underlying inflation measure could finish the year "a shade below 3, maybe around 3" percent, compared with the central bank's 2% target. He added that there are risks it could be even higher.
Given that outlook, Musalem said the Fed could hold its policy rate in the present 3.50%-3.75% band "for some time," while monitoring incoming data on inflation, employment and broader economic activity over the coming months. That view, he said, is shared by many colleagues on the central bank's policy-setting committee.
Musalem noted the COVID-era tariff increases and elevated housing price inflation have been moving in directions that temper price growth. He said the impact of last year's tariff rises is likely to fade in the current quarter, and that housing-related inflation is easing.
But he emphasized that the recent jump in oil - with Brent crude around $95 a barrel versus about $70 before the start of the U.S.-Israeli war with Iran - has already translated quickly to higher gasoline prices and is likely to push up shipping, travel and food costs through higher input prices such as fertilizer.
Those forces, he said, have the potential to offset the disinflationary effects elsewhere in the economy. On services inflation, Musalem observed that core non-housing services remain elevated even as housing contributes most of the decline in inflation measures and goods have moved in the opposite direction.
Reflecting that mix of influences, Musalem said monetary policy at present "is in a good place, and I think it's probably going to be appropriate to maintain policy at this level for some time." He added that the Fed needs to see "all components of inflation come down in a balanced way."
He cautioned that if inflation begins to move higher in a way that threatens to pull up inflation expectations, the central bank should be prepared to act. "If it gets worse," he said, "the risk of de-anchoring inflation expectations would become relevant. Right now, inflation expectations medium to long term are very anchored, but they would become relevant, and at that point it might be appropriate to raise rates."
Musalem described the oil shock as "the third negative supply shock in 12 months," alongside rising tariff rates and tighter immigration rules. He said those supply-side developments pose risks both to the inflation outlook and to the labor market by potentially knocking growth lower.
On the labor market and growth, Musalem said it is still too soon to see a clear impact on overall consumer spending, though he expects the unemployment rate may tick up slightly. He said he anticipates slower growth this year, while still expecting growth to fall in the range of 1.5% to 2%.
Summing up the trade-offs facing policymakers, Musalem said there are "two-sided risks to rates. Risks have increased on both sides of the mandate, towards higher inflation and towards the weaker labor market ... If you add the two things together, policy is well positioned where it is currently."
Key takeaways
- High oil prices are expected to keep core inflation near 3% for the remainder of the year, above the Fed's 2% target.
- The Fed's policy rate is likely to remain at 3.50%-3.75% "for some time," with officials watching inflation, jobs and economic data before making further moves.
- Musalem is open to raising rates if inflation accelerates and risks de-anchoring medium- to long-term inflation expectations.
Sectors likely affected
- Energy - higher oil and gasoline prices influence inflation directly.
- Transportation and travel - increased fuel costs raise shipping and travel expenses.
- Agriculture and food - higher input costs such as fertilizer can lift food prices.
- Housing and consumer services - dynamics in housing and services continue to shape overall inflation.
Risks and uncertainties
- Oil-driven inflation shock: Continued elevated oil prices could sustain or increase core inflation, affecting energy, transport, and food sectors.
- Inflation expectations: If inflation starts to accelerate and pulls up medium- to long-term expectations, the Fed may need to raise rates, which would affect borrowing costs across the economy.
- Growth and labor-market pressure: Supply shocks from oil, tariffs and immigration rules could weaken growth and raise unemployment modestly, impacting demand-sensitive industries.
The Fed's near-term stance, according to Musalem, is one of cautious patience: policy remains restrictive enough to address inflation risks, but officials are prepared to adjust if price trends or expectations move in a troubling direction. For sectors exposed to energy, transportation, and agricultural inputs, the interplay between oil prices and underlying inflation will be particularly important in the months ahead.