Fed's Alberto Musalem Talks Fed Policy

Summary

Bloomberg Talks: Fed's Alberto Musalem Talks Fed Policy

Host: Stephanie Flanders (Bloomberg)
Guest: Alberto Musalem (President, St. Louis Fed)
Date: May 28, 2026

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Episode Overview

This episode features a wide-ranging, in-depth conversation with San Francisco and St. Louis Fed President Alberto Musalem from the Reykjavik Economic Conference. The discussion, led by Bloomberg’s Stephanie Flanders, explores the state of US monetary policy, inflation risks, the impact of AI on productivity and rates, implications of rising bond yields, and anticipated changes under the incoming Fed chair, Kevin Warsh. Musalem offers a candid assessment of possible rate paths, scenarios for inflation and growth, and the future of Fed communication and balance sheet strategy.

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Key Discussion Points & Insights

1. Current Monetary Policy Stance and Inflation Risks

• Real Policy Rate Below Neutral:
  • Musalem observes that the real policy rate is ~0.5%, below the FOMC's 1% neutral rate, meaning policy is "at or slightly below the committee's long run neutral level."

    “Their real policy rate right now is running at around half a percent, which is lower than the 1% that the committee believes is the neutral rate.” (Musalem, 01:35)

• Risks Shifted Toward Inflation:
  • He feels the "easing bias was no longer consistent with the outlook," with risks now more on the inflation side than employment.

    “In my mind the balance of risk has shifted a little bit toward the inflation side and less towards the employment side.” (Musalem, 02:17)

• Policy Scenarios:
  • Musalem foresees:
    • A scenario with persistent inflation requiring a hike
    • A weaker growth scenario with room for cuts

    “There is a scenario where inflation remains high...the economy will probably require a hike...there's also a scenario where the economy weakens...and that scenario we would be thinking of no hikes, maybe even a cut.” (Musalem, 02:26)

2. Interest Rate Outlook & Market Pricing

• Markets Pricing for 2027 Hike:
  • Musalem doesn't comment directly on market forecasts, stressing the Fed's priority is what's "best for the economy and Main Street."

    “Markets have repriced materially...that's markets trying to understand what our reaction function is.” (Musalem, 03:28)

3. AI, Productivity, and Inflation

• Short-Term Inflationary Impact:
  • Musalem, while optimistic about AI’s potential, cautions against relying on it for near-term disinflation.
    • Data center build-outs and chip demand exert upward pressure on inflation, especially in specialized labor and capex.

    “What AI is doing right now...it's putting upward demand pressures...through chip prices for the buildout. In my district I hear of construction companies shipping workers all over the country...to build out the data center.” (Musalem, 04:24)

• Potential Long-Term Impact:
  • If productivity growth becomes permanent, it could raise real rates; if transitory, rates could fall.

    “If it’s expected to be very permanent, that will put upward pressure on real interest rates. If it’s expected to be transitory, then the supply side will win and that will put downward pressure on interest rates.” (Musalem, 06:58)

• AI’s Effect on Labor:
  • Acknowledges the potential for disinflation from job losses, but currently sees demand-side pressures as more prominent.

    “In the short run, I think the demand pressures are more prominent than the supply relief...” (Musalem, 06:13)

4. Bond Yields, Term Premium, and Financial Conditions

• Drivers of Higher Yields:
  • Musalem attributes rising yields more to a higher expected neutral policy rate than term premium increases.

    “About three quarters of it was an increase in the expected neutral rate policy rate and about one quarter higher term premia.” (Musalem, 07:58)

• On Financial Conditions Tightening:
  • While forward real rates have risen, he hesitates to say the bond market has done the Fed’s work for it.

    “Markets have raised the real implied forward...a year from now...two years from now have come up meaningfully in the last month or two.” (Musalem, 08:20)

5. Fed Communications and Chair Kevin Warsh’s Approach

• Planned Shift Away from Forward Guidance:
  • Warsh wants less forward guidance, fewer speeches, and to remove the dot plot, but Musalem favors transparency about the Fed’s "reaction function.”

    “What I would like the most...is that we have a communications policy that is very effective at transmitting what our reaction function is at any point in time.” (Musalem, 10:29)

• Differences Over Communication Tools:
  • Musalem prefers enhancing the interpretability of the dot plot, instead of abolishing it.

    “Right now we have the dots, we can make the dots more effective by connecting the dots...Now you could also think of not having the dots but replacing them with something else...” (Musalem, 10:31)

• Warsh's Learning Curve:
  • Given Warsh's prior Fed experience, Musalem expects a "much lower" learning curve.

    “His learning curve will probably be much lower than somebody who had not been there before.” (Musalem, 09:33)

6. Balance Sheet Reduction Debate

• Views on Shrinking the Fed’s Balance Sheet:
  • Musalem advocates for careful study, distinguishing between cutting from the supply vs. demand side of reserves, and favors a cautious approach.

    “If we went in the direction of taking measures that would reduce the banking system's demand for reserves, then that would be...a smoother path towards a lower balance sheet...than simply reducing supply, which could be disruptive...” (Musalem, 11:25)

• Optimal Size of the Balance Sheet:
  • Sees merit both in a larger and smaller balance sheet, valuing “the minimum balance sheet that [the Fed] needs.”

    “There are some benefits to having a large balance sheet in terms of financial stability, but...it's also...healthy for the central bank to have the minimal or minimum balance sheet that it needs...” (Musalem, 12:13)

7. Public Perception and External Pressures

• Fed’s Mandate amid Energy and AI Shocks:
  • Musalem underlines the Fed’s statutory responsibility for price stability, regardless of whether drivers are external (energy, AI) or domestic.

    “Our mandate is price stability and maximum employment. And right now we're above target on inflation...so...the probability that we might consider an interest rate increase in the future...has to be greater than zero.” (Musalema, 13:18)

8. Kevin Warsh’s Leadership Style

• Agent of Change:
  • Musalem expects Warsh to bring an appetite for fundamental questioning and change, which he sees as refreshing.

    “I think the new chair...will be asking some very profound and deep questions...I think that's refreshing. A new leader should always come in with a vision and asking very deep questions about how things were done in the past.” (Musalem, 14:22)

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Notable Quotes & Memorable Moments

• On Policy Scenarios:

  “There is a scenario where inflation remains high...the economy will probably require a hike ...and that scenario...we would be thinking of...maybe even a cut.” (Musalem, 02:26)

• On AI’s Immediate Economic Impact:

  “To rely on productivity to do the inflation job seems a risky proposition because what if the productivity doesn’t materialize in the future? We could end up with higher inflation today and in the future.” (Musalem, 04:24)

• On Communication with Markets:

  “What I would like the most...is that we have a communications policy that is very effective at transmitting what our reaction function is at any point in time.” (Musalem, 10:29)

• On Fed Mandate and Rate Hikes:

  “The possibility or probability that we might consider an interest rate increase in the future I think has to be greater than zero.” (Musalem, 13:18)

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Important Timestamps

• 00:57 – Start of interview with Alberto Musalem
• 01:35 – Musalem on real policy rate and inflation above target
• 02:17 – Balance of risks has shifted toward inflation
• 03:10 – Scenarios for future rate hikes or cuts
• 04:24 – AI as a current inflationary force
• 06:13 – Short-term: AI demand pressures outweigh supply relief
• 07:40 – Causes of higher bond yields
• 08:20 – Forward real interest rates rising
• 09:09 – Incoming Chair Warsh’s view on Fed communication
• 10:29 – Musalem on improving or replacing the dot plot
• 11:25 – Balance sheet reduction: demand vs. supply approach
• 12:13 – Musalem on optimal balance sheet size
• 13:18 – Why the Fed can’t ignore energy or AI when considering hikes
• 14:22 – What to expect from Chair Warsh's leadership

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Conclusion

Alberto Musalem offers clarity and nuance on the Fed's current thinking in a period of heightened economic uncertainty. He sees significant inflation risks, remains agnostic but vigilant regarding AI-driven productivity, and prefers clear and adaptable Fed communications. Musalem’s remarks underscore the complexities facing the incoming Fed chair, including communication strategies and the delicate balance between supporting growth and reining in inflation—challenges magnified by technology, geopolitics, and shifting market expectations.

Transcript

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Radio News we consider the path forward for this conflict and of course, ultimately what it means for the global economy. That is a challenge that polit policymakers have to deal with not just on Capitol Hill, but inside the Federal Reserve Building, in the various buildings across the country that the Fed inhabits as they consider the economic picture and the inflation picture that this has created. And it's on that note, we turn now to the Reykjavik Economic Conference where The San Francisco St. Louis Fed President Alberto Musalim is sitting down with Bloomberg's very own Stephanie Flanders. Let's go live now to Iceland.

[Stephanie Flanders]

Well, thank you so much. I am indeed here in Reykjavik with Alberto Musala. Thank you very much for joining us. In your speech here at this conference, you pointed out that the US has inflation running meaningfully above target, long run inflation expectations creeping higher and yet a real policy rate that was below the level that the Federal Open Market Committee think is is neutral. So not actually applying any restraining force on the economy that all those things together sound like someone who wants to raise interest rates.

[Alberto Musalem]

Great to be with View. That's right. Their real policy rate right now is running at around half a percent, which is lower than the 1% that the committee believes is the neutral rate. I think you have to look at the full picture and it looks to me like policy is at or slightly below the committee's long run neutral level.

[Stephanie Flanders]

But if you combine that with the other things you talk about, you had emphasized the risks of the inflationary pressures on the demand side and the supply side of the economy. It just, it sounds like you think they should be leaning towards tightening. It sounds like you, you might have been one of the policymakers in the April meeting who actually thought they should have removed the the statement against tightening in the in the statement.

[Alberto Musalem]

So yes, I supported the interest rate decision, but I thought the easing bias was no longer consistent with the outlook and the balance of risks, which in my mind the balance of risk has shifted a little bit towards the inflation side and less towards the employment side. So whether the economy will require a hike or a cut or hold will depend on the scenario. There is a scenario where inflation remains high. There's no disinflation in the next quarter or two, and in that scenario the economy will probably require a hike. There's also a scenario where the economy weakens materially in the second half of the year because real incomes are challenged and corporate margins are challenged. In that scenario inflation could come down and that scenario we would be thinking of no hikes, maybe even a cut. So. So there are two scenarios to play with here.

[Stephanie Flanders]

But looking down the track at least the markets are now fully pricing a rate hike by March 2027. Given where we are now, how we think things are going to proceed with oil prices and some of the risks on the supply side that you talk about, do you think that's a sensible thing for them to price again?

[Alberto Musalem]

I think, I think there are two scenarios here and I don't comment normal market pricing. I'm more focused on what's best for the economy and for Main street markets have repriced materially in the US and in other countries in the front end of the curve. I think that's markets trying to understand what our reaction function is.

[Stephanie Flanders]

So I'm going to quote here because in your speech you talk very directly about the impact of AI on productivity and the long run impact that could have on monetary policy and on interest rates. But you warn that policymakers cannot depend on a potential productivity boost room from artificial intelligence to ease elevated inflation right now in the short term. And in fact you seem to suggest that the build out of all the data centers associated with AI was actually putting upward pressure on inflation. Do you think the incoming Fed chairman Kevin Walsh is one of those policymakers that's inclined to be hoping for that?

[Alberto Musalem]

So I'll speak about my views. I am an AI enthusiast and productivity optimistic but at present it's unclear that productivity first of all is higher than the long term average. It's actually at or below the long term average. And so to rely on productivity to do the inflation job seems a risky proposition because what if the productivity doesn't materialize in the future? We could end up with higher inflation today and in the future. And what AI is doing right now, it's not really expanding the supply side of the economy yet. What it's doing is it's putting upward demand pressures, you know, through, through chip prices for the build out. In my district I hear of construction companies, shipping workers all over the country. This is specialized trades persons to to build out the data center. So at present it's more of a demand story from AI than a supply story. And you see that in the agri demand numbers and the percentage of capex that is coming from the AI buildout is material.

[Stephanie Flanders]

But of course A lot of this does come down to how you think in the scenario the next sort of year and a half that that's what you're focused on. When you think about where the policy is right now and in the next few quarters, there's obviously different pressures. Right? There's. Some have emphasized, even John Williams has talked about the disinflationary forces that come from AI. If you start to see people lose their jobs, if you see jobs eliminated as AI is rolled out, you've highlighted more of the supply side, this of up pressures that come from data centers and other things, those kind of pressures on resources. You seem pretty clear that those upside pressures are going to be the larger factor, at least coming from the AI revolution in the next year.

[Alberto Musalem]

I think there are two things. In the short run, I think the demand pressures are more prominent than the supply relief. I'm prepared to change my view if and when I see AI actually contributing to agri productivity growth, which we don't see just yet in the data, and when that becomes evident that that's actually putting down pressure on inflation at present, that's not where we are now in terms of the long run productivity and AI. If and when we get productivity to grow above its long run average, where it currently right now is not, the impact on real interest rates will depend on how permanent that increase in productivity growth is expected to be. If it's expected to be very permanent, that that will put upward pressure on real interest rates. If it's expected to be transitory, then the supply side will win and that will put downward pressure on interest rates.

[Stephanie Flanders]

One other thing that's happened since the beginning of the Iran crisis is a real change in bond yields. And actually we certainly think on Bloomberg Economics, we think that's been largely due to an increase in the term premium, slightly an increase in what we're expecting on inflation, but mainly on the on the term premium. So in that sense markets has, has that the bond market already done some of the Fed's work for it? I mean, is that producing a meaningful tightening even though you have a very low short term rate?

[Alberto Musalem]

So my interpretation of what's happened to bond markets is that they're seeing an economy that's resilient. On the real side, they see a labor market that's been resilient. On the real side, they see higher realized inflation, they see higher expected inflation. When I look at the decomposition, I arrive at a different conclusion than your team, which is a fantastic team. My understanding it's about three quarters of it was an increase in the expected neutral rate policy rate that is and about one quarter higher term premia. Now if you look at forward markets.

[Stephanie Flanders]

So just on that, you don't think it is hasn't meaningfully tightened financial conditions if you're looking on that kind of medium term.

[Alberto Musalem]

So I was about to say if you look at the forward real interest rates, markets have raised the real implied forward. So the real interest rate a year from now, the real interest rate two years from now have come up meaningfully in the last month or two.

[Stephanie Flanders]

But just going back to think, you don't think that it's made the incoming Kevin Walsh is not his job hasn't been made any easier by the tightening in the bond market. You still, you would still have to be focused on that short term rate.

[Alberto Musalem]

I think when he comes in he's going to take a look at the, oh, he has come in, he's been sworn in. You know, he's going to, he's going to have his first meeting next, next two weeks and he's going to have to look at the economy and we're all going to have to look at the economy and you know, exchange views on the economy and exchange views on what the best policy for the American people is at that point in time.

[Stephanie Flanders]

Well, the other thing that the incoming Fed chair has talked a lot about is changing the Fed's communication tools. He said he doesn't want to see so much or indeed any forward guidance. He wants to have fewer public speeches. He wants to get rid of the dot plot. Lots of people come in saying they want to have less, less forward guidance and then they find they want to say things to the markets. Do you think that he's going to have a similar kind of learning curve?

[Alberto Musalem]

Well, he's, he's been in the Fed before, so he, his learning curve will probably be much lower than somebody who had not been there before. You know, he's expressed some views during the last year or so. Once he's in the seat, once he consults with the full committee and I expect him to consult with the full committee on all these matters. You know, he will try and steer the committee in a direction or another. And I think it's always healthy to look at your communications policy, your monetary policy framework and see how to adjust each or both to make sure we're fulfilling the dual mandate as best we can.

[Stephanie Flanders]

But you're kind of on the opposite side of this because you wanted to actually connect the dots to whole forecasts, not reveal whose dots they were, but Make a bit more sense of what the dots represented, the bigger picture. Whereas he, instead of elaborating on the dots, he wants to get rid of them altogether. I mean, that's just a straightforward disagreement, right?

[Alberto Musalem]

Well, I would say what I think I would like the most favor the most is that we have a communications policy that is very effective at transmitting what our reaction function is at any point in time. Right now we have the dots, we can make the dots more effective by connecting the dots in terms of transmitting our reaction function. Now you could also think of not having the dots but replacing them with something else that is effective in transmitting to the markets and households and businesses what our reaction function is.

[Stephanie Flanders]

The other big thing that certainly people in the financial markets have been very focused on in Kevin Walsh's comments is about wanting to shrink the Fed's balance sheet. And actually Governor Michael Barr said just the other day that he thought that was just the wrong goal, that it would actually raise risk for financial stability and that it wouldn't necessarily reduce the Fed's footprint in financial markets. What do you make of that?

[Alberto Musalem]

I think that something needs to be studied and we need to all, you know, review what the options are for doing that if we so desired. And I think it's very different to reduce the balance sheet from the supply side, which could be very disruptive, or reduce the balance sheet from the demand side for reserves. Demand for reserves as opposed to supply for reserves. If we went in the direction of taking measures that would reduce the banking system's demand for reserves, then that would be, I think, a smoother path towards a lower balance sheet and percent of GDP or a lower growth of the balance sheet in nominal terms than simply reducing supply, which could be disruptive but other things equal.

[Stephanie Flanders]

Do you kind of share the desire on balance to have a smaller balance sheet?

[Alberto Musalem]

I think there, I'm going to do a two handed economist now. There are some benefits to having a large balance sheet in terms of financial stability, but it's also, I think healthy for the central bank to have the minimal or minimum balance sheet that it needs to have to operate its monetary framework and to promote financial stability. So I think we need to understand where that, where that is just a last question.

[Stephanie Flanders]

When you talk about communications, and we've certainly had a lot of communications about the Fed from the White House. But also we have ordinary people who are coping with the impact of higher gasoline prices. We're definitely having a conversation about higher interest rates now that we wouldn't have expected to have six months ago. And I think a lot of people, whether in the White House or in the broader economy would say, hang on, what is, what is the Fed doing thinking about raising interest rates in an environment where it can't affect the global energy price? That's the thing pushing up inflation. And it definitely can't affect the rollout of AI because that seems to be just an unstoppable force. So why, why raise interest rates?

[Alberto Musalem]

So our mandate is price stability and maximum employment. And right now we're, we're above target on inflation. And so the possibility or probability that we might consider an interest rate increase in the future I think has to be greater than zero. You know, the economy has been robust, GDP growth has been at or around potential. The labour market is right around, in terms of unemployment, right around its natural rate around 4.3, 4.4. And so we're missing on one side of the mandate, inflation expectations are drifting higher to some degree. And we're not missing on the other side of the mandate. So you have to take all the factors and you know, we have a statutory responsibility to hit both sides of the mandate.

[Stephanie Flanders]

And finally, you did mention Kevin Water is sort of is in the building and has been sworn in. He talked in the past about wanting to shake, you know, break some heads and have a sort of revolution, be it be an agent of change in the Fed. Is that the way that he's presented himself internally?

[Alberto Musalem]

I think, I think the new chair or chair Warsh I should say, will be asking some very profound and deep questions about many ways in which we operate, you know, monetary policy, communications, operations. And so I think that's refreshing. You know, a new leader should always come in with a vision and asking very deep questions about how things were done in the past. I expect that to be the case.

[Stephanie Flanders]

Alberto Masalam, thank you very much for joining us. And I think we'll even forgive you for disagreeing with our US Economics team. Thanks very much.

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