Fed's Musalem flags risk of rising inflation expectations and stagflation

By Howard Schneider

WASHINGTON, Feb 20 (Reuters) - St. Louis Fed President Alberto Musalem on Thursday raised the twin risks of rising inflation expectations and difficult-to-address stagflation, in remarks that highlighted the potentially difficult choices facing the U.S. central bank.

While many of his colleagues say they regard inflation expectations as anchored, Musalem said he was concerned recent data showed they may be rising - a development that might force the Fed onto a more restrictive path.

"In the current environment, the stakes are higher than they would be if inflation was at or below target," Musalem said in comments prepared for delivery to the Economic Club of New York. "The risk that inflation expectations could become unanchored is higher than it would be if the economy was operating with slack and if consumers and businesses had not recently experienced a period of high inflation."

While he said he still feels inflation will converge to the Fed's 2% target, "market and some survey measures indicate that near-term expectations of inflation have risen notably over the past three months," Musalem said. If inflation does get stuck at current above-target levels or expectations do rise, "a more restrictive path of monetary policy relative to the baseline path might be appropriate."

Musalem's remarks did not give his current view about rate-cut expectations for this year.

But his warnings spoke to the possible complications surrounding the Fed's main narrative of falling inflation and eventual further rate cuts, an outlook that has remained the baseline even as officials acknowledge the possible impact on prices of new Trump administration import taxes and immigration rules.

That remains Musalem's core outlook as well, with monetary policy remaining restrictive "until inflation convergence is assured."

But coming policy shifts "could materially affect the path of the economy," he said. "The risks of inflation stalling above 2% or moving higher seem skewed to the upside ... An alternative and plausible scenario in which inflation ceases to converge, or rises, at the same time the labor market weakens must also be considered."

The combination of slowing growth and high inflation is a worst-case scenario for central bankers, leaving the Fed with tension between its employment and inflation goals and forced to choose which one to prioritize.