Federal Reserve's Moussallem believes the policy interest rate may remain at an appropriate level for some time

Investing.com – Federal Reserve Bank of St. Louis President Alberto Musalem said Wednesday that the current policy interest rate may remain at a level that is appropriate for some time, as the Fed balances risks related to employment and inflation.

Musalem said in remarks at the Washington, DC-based American Enterprise Institute that he supports the Federal Open Market Committee’s recent decision to keep the policy rate in the 3.5% to 3.75% range. He said that, before the recent rise in energy prices, the real policy rate—adjusted for inflation expectations—was already in the neutral range, and has since fallen further.

Musalem said the economic outlook is highly uncertain. The baseline scenario for 2026 is that real GDP growth is close to potential, the unemployment rate remains near its current level, and core inflation begins to gradually ease back to 2% later in the year. He said that risks to both the labor market and inflation are tilting in an unfavorable direction—meaning a weakening labor market and more persistent inflation above target.

Real GDP growth slowed somewhat in the fourth quarter, in part due to a government shutdown, but final sales to domestic private buyers grew at a respectable pace. Tracking forecasts show that growth in the first quarter is close to potential.

Consumer spending in the first two months of 2026 was soft, partly because of winter storms, but solid wage growth, fiscal policy, and wealth effects should support consumer spending over the next several quarters. It is expected that the average 2026 federal income tax refund per household will be about $1,000 more than last year, and households will also receive additional tax relief from lower withholding.

Musalem said uncertainty stemming from the Middle East conflict and tariff policies is likely to put pressure on consumer and business spending in the first half of this year. Rising prices for fuels, aluminum, and fertilizer—prices that are sensitive to disruptions in supply chains—could also weigh on spending. Estimates from St. Louis Fed staff indicate that the rise in fuel prices since the conflict began could make consumers lose an amount equivalent to roughly 10% to 15% of this year’s tax relief per quarter if fuel prices stay at their current level.

The labor market has gradually cooled over the past 18 months, and recent data suggest it may have stabilized, even though it is in a “low hiring, low layoffs” state. Since mid-2023, the unemployment rate has gradually risen, but remains close to the natural unemployment rate. The ratio of job openings to the number of unemployed has edged down slightly since 2023, but it is still well above its long-term average.

Musalem said he believes labor market risks are skewed to the downside. The three-month growth rates for total employment and private-sector employment are concentrated in only a handful of segments and are at the low end of the estimated break-even rates needed to prevent unemployment from rising.

Core PCE inflation in January was 3.1%, and estimates show that February’s change was little to no different. Core services inflation excluding housing has proven to be sticky, and rising core goods prices are also one of the reasons inflation has continued to persist in recent months.

Estimates from St. Louis Fed staff indicate that tariffs could explain about half of the 12-month excess inflation above 2%. The effect of tariffs implemented last year on inflation should fade over the next few quarters. Musalem said he had previously expected core PCE inflation to start moving toward 2% in the second half of 2026, but developments in geopolitics cast a shadow over that outlook, and he now thinks the risk that inflation stays above target for all of 2026 is greater.

The recent rise in energy prices will create upward pressure on overall inflation in the near term, and will partly feed through to core inflation. A business survey in March found that firms are passing higher energy prices on to customers and recording the largest increase in selling prices since August 2022.

Musalem said that if a bigger risk of labor market weakness becomes evident, he can support further easing as long as inflation and inflation expectations do not continue to rise. If actual or expected inflation falls, he can also support lowering the policy interest rate to prevent real rates from rising.

He can support raising the policy interest rate to avoid an unintended easing of real conditions caused by holding the policy rate unchanged when core inflation—or medium- to long-term inflation expectations—keeps rising and diverges from 2%.

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