WASHINGTON, April 1 (Reuters) - St. Louis Federal Reserve President Alberto Musalem said on Wednesday he doesn't see a near-term need for the U.S. central bank to change its interest rate stance, as he warned of rising inflation risks tied to the war in the Middle East.
"Policy is well positioned to address risks to both dual mandate objectives, and I expect the current setting of the policy rate will remain appropriate for some time," Musalem said in a speech at the American Enterprise Institute in Washington.
"The economic outlook is highly uncertain," he said. And while the baseline outlook holds for decent levels of growth, stability in the unemployment rate and further moderation in inflation, he added that "uncertainty from the Middle East conflict and unsettled tariff policy could weigh on consumer and business spending in the first half of the year."
Musalem also said "higher fuel, aluminum and fertilizer prices" could weigh on the economy.
In this environment, Musalem said job market and inflation risks "both tilt in unfavorable directions, that is, toward a weaker labor market and greater persistence of above-target inflation."
He noted that it's been an extended practice for the Fed to look through supply shocks as likely temporary drivers of higher inflation, but the current situation may be different.
"History suggests caution is warranted, however, especially when underlying inflation is persistently above target," Musalem said. "Supply shocks may be more likely to have a persistent impact on inflation and inflation expectations, especially given the difficulty of identifying how much underlying inflation is due to temporary supply shocks as opposed to persistent demand pressures."
"My expectation is that headline inflation is going to be affected one for one" by the surge in commodity prices "and there's going to be a period of high headline inflation," Musalem said. "There will be some pass through to core inflation also," all of which will merit close monitoring, he said.
On Wednesday, the Cleveland Fed's real-time inflation estimates showed signs of price pressures building. Estimates of the consumer price index and personal consumption expenditures price index showed that on a year-over-year basis April CPI inflation now stands at 3.71%, up from the March CPI nowcast of 3.25%. The Fed's preferred inflation measure, the PCE index, stood at 3.58% for April versus 3.28% for March. Meanwhile, core prices, which exclude food and energy, showed less of an impact.
Musalem warned that even a swift resolution to the combat kicked off by the U.S.-Israeli war on Iran will have a hangover impact on the economy. "Even if the war were to end, it's going to take time to bring a lot of the damaged capacity back, back on stream." He said he'd be looking for "echoes" of these developments in the data to see how to respond with policy.
FED OUTLOOK CLOUDED BY UNCERTAINTY
The Fed last month maintained its benchmark overnight interest rate in the 3.50%-3.75% range as it awaits data on the impact of the U.S.-Israeli war with Iran, which has led to a surge in energy prices and has started to upend key global supply chains.
At its recent policy meeting and in comments since then, Fed officials have given no signals they see an imminent need to change interest rate policy. The last Fed meeting saw officials pencil in one rate cut for this year, as financial markets have oscillated between expectations of hikes and cuts due to the inflation outlook.
Musalem said there could be cases for both lowering and lifting rates at some point.
He said he could favor easing policy if "a greater risk of a weakening labor market becomes apparent" so long as risks of higher inflation are low. As for a hike, he said that could be in the cards "to avoid an inadvertent real easing that would result from holding the policy rate constant if core inflation or medium- to long-term inflation expectations moved persistently higher and away from (the) 2%" target.
Musalem also said financial conditions are still "broadly accommodative" and stress in private credit markets is largely limited to that sector and is not a sign of broader woes.
(Reporting by Michael S. Derby; Editing by Paul Simao and Andrea Ricci )
By Michael S. Derby and David Lawder
