Fed's Musalem flags risk of rising inflation expectations

Updates with further comment

By Howard Schneider and Michael S. Derby

Feb 20 (Reuters) - St. Louis Federal Reserve President Alberto Musalem on Thursday raised the twin risks of rising inflation expectations and a labor market that weakens alongside rising prices, 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 a speech given before 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."

In comments to reporters after his speech, Musalem said "a durable convergence" of inflation back to the 2% target would help give him confidence the Fed could cut rates again, but he offered no timetable for that to happen.

He also told reporters "my baseline scenario is one where inflation continues to converge towards 2% provided monetary policy remains modestly restrictive and it will take time” for that to happen, while adding "I see the risks of inflation staying above the (2%) target as skewed to the upside."

Musalem's 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. "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 a weakening labor market alongside high inflation is a difficult scenario for central bankers, leaving them with tension between their employment and inflation goals and forced to choose which one to prioritize.

Musalem said he did not, however, see the risk of rising inflation and a weaker labor market as significant enough to be considered "stagflation."