Fed’s Barr skeptical that inflation has been tamed

• Key insight: Federal Reserve Gov. Michael Barr said in a speech Thursday that he fears the way tariff price increases are being passed on to consumers could result in an unmooring of inflation expectations, potentially leading to more inflation — and higher interest rates — down the road.
• Expert quote: “While, in principle, tariffs are a one-time increase in prices and should not sustainably raise inflation, that may not be the case if prices keep rising month after month and affect expectations.” — Federal Reserve Gov. Michael Barr 
• What’s at stake: Barr’s views come in contrast with other Fed officials’ recent remarks, which focused on the risks to the labor market of maintaining higher interest rates for too long.

Federal Reserve Gov. Michael Barr said he is worried that the persistently high inflation rate observed in recent months could lead to higher consumer expectations of inflation over the long run, a phenomenon that would likely necessitate higher interest rates to counter.

Speaking at a conference at the Federal Reserve Bank of Minneapolis Thursday, Barr — who had served as the Fed’s vice chair for supervision until February — said that the way that price increases due to new tariffs have been passed on to consumers to date has led to lower headline inflation rates than many economists expected earlier this year. 

Part of that, he said, is because many retailers built up stockpiles of imported materials in anticipation of the new tariffs and have been using a combination of those stockpiles and thinner profit margins to keep price increases at the port from hitting consumers on-shore.

“While the immediate effects of tariffs on inflation have been smaller than most economic forecasters had expected, the inventories built up in anticipation of the tariffs may have had a role in easing the immediate impact, as have compressed profit margins,” Barr said. “While that is good news for inflation, the corresponding bad news is that firms will eventually run down those inventories and will only be able to compress margins for a while.”

The effect of this softening of the one-time inflationary blow is to stretch that price increase out over time, which has the potential to lead consumers to expect inflation to continue even after the tariff-induced price increases have been absorbed.

“Normalizing margins over time implies a gradual, but longer, upward trajectory for inflation, a pattern of price increases that I fear could convince many consumers that higher inflation is going to be more of a permanent phenomenon,” Barr said. “While, in principle, tariffs are a one-time increase in prices and should not sustainably raise inflation, that may not be the case if prices keep rising month after month and affect expectations. At some point, businesses and consumers could start to make pricing, spending and wage decisions based on their belief in higher future inflation, thereby driving a cycle of persistence.”

Barr’s remarks come in contrast with those of other Fed officials in recent days. 

Fed Vice Chair for Supervision Michelle Bowman said in a speech last month that the labor market is at risk of “serious deterioration” and that further weakening of the jobs numbers could spur the central bank to cut interest rates “at a faster pace and to a larger degree going forward.”

Bowman’s remarks echoed those of recently-confirmed Fed Gov. Stephen Miran, who last month argued that there has been a paradigmatic shift in the economy that the central bank has not sufficiently considered. Higher rates of immigration and fiscal policy observed in the Biden administration resulted in a higher neutral rate — that is, the interest rate that is neither accommodative nor restrictive to the economy — than central bankers appreciated. That miscalibration is now being thrown into reverse, Miran argued, because the immigration and fiscal policies enacted by the Trump administration are pushing the neutral rate lower than the Fed consensus thinks, rendering the current Fed rate considerably more restrictive than Fed officials think. 

“In my view, insufficiently accounting for the strong downward pressure on the neutral rate resulting from changes in border and fiscal policies is leading some to believe policy is less restrictive than it actually is,” Miran said.

Barr acknowledged that the gradual rollout of price increases may not necessarily lead to long-term inflation. The softening labor market could result in downward pressure on wages, which could at least partially counteract inflationary pressures, Barr said, noting that the gradual increase in prices has not spurred supply chain dislocations and that consumer inflation expectations to date have been well anchored. 

But he also noted that the labor market may not be in as perilous a position as it may seem. The delayed release of the Bureau of Labor Statistics’ September jobs report means that Fed officials don’t have the most reliable data on labor market deterioration, though private metrics suggest a modest contraction in the number of jobs in the economy last month. Even so, simultaneous reductions in labor supply stemming from the administration’s immigration policies have blunted the reduction in labor demand, meaning that small rates of job creation may be healthier than they might otherwise appear. 

“With a reduced supply of labor, what constitutes a healthy growth rate for employment would be smaller,” Barr said. “One can see that slower labor supply growth has been an important factor in the weaker job creation, because over the period that job gains have slowed significantly, the unemployment rate has only edged up to 4.3%, a level typically associated with a sound labor market.”

The rough balance of the labor market, however, should not be confused with stability, Barr said, noting that the labor market is still susceptible to destabilizing outside shocks that could throw the market out of balance. Workers’ confidence in their ability to find another job if they lost their current one is the lowest it has been in more than a decade, Barr said, and unemployment rates for black and young workers — populations that often serve as the leading edge of labor dislocations — have been edging up in recent months. All of that paints a picture of a roughly balanced but highly delicate labor market, Barr said. 

“With job growth near zero for the past several months, the labor market could decline precipitously if the economy is hit with another shock,” Barr said. “With the easing in output growth and the likelihood of tariffs and labor supply weighing on the economy in the months ahead, we need to be prepared for the possibility that the softening in the labor market will become something worse, especially if there is a further adverse shock to demand.”

Looking toward the Fed’s near-term monetary policy stance, Barr said he supported the Federal Open Market Committee’s decision last month to reduce the federal funds rate by 25 basis points, which he said sensibly brought the prevailing rate “a bit closer toward neutral.” Since that time, Barr said, inflation has shown to remain persistently higher than the Fed’s 2% target rate but consumer spending has shown to be more robust than expected. In the absence of an overpowering development favoring one side of the Fed’s dual mandate over the other, the central bank should remain cautious in its future decisions, Barr said. 

“I believe that … the FOMC should be cautious about adjusting policy so that we can gather further data, update our forecasts, and better assess the balance of risks,” Barr said. “If we see inflation moving further away from our target, then it may be necessary to keep policy at least modestly restrictive for longer. If we see heightened risks in the labor market, then we may need to move more quickly to ease policy. The FOMC can, and I believe would, act forcefully to stabilize the economy if necessary.”