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The Fed's 'key focus' is preventing wage inflation spiral and a higher inflation regime: Economist

Greg Daco, chief economist at EY-Parthenon, joins Yahoo Finance Live to explain where the Fed is at in terms of tackling record inflation in the country.

Video Transcript

SEANA SMITH: We have rising food prices, rising gas prices, pushing inflation to the highest levels that we've seen since 1981. It's fueling bets that the Fed will get even more aggressive to fight inflation. We want to bring in Greg Daco. He's EY Parthenon chief economist. So, Greg, the big question is, we have this very, very hot inflation print. What should the Fed do next? How do you see or how do you think the Fed should address this, just in terms of their policy? How much more aggressive should they potentially get?

GREG DACO: Well, I think what we're seeing right now in terms of inflation dynamics is that it's fairly broad-based inflation dynamics. It's not just one sector that is seeing higher prices. As Brooke was saying, we're seeing grocery store prices rising. We're seeing energy prices rising. We're seeing goods prices rising, service prices rising, housing prices rising. Everything is rising in terms of inflation. And that's certainly not the type of context that the Fed appreciates. The Fed would like to see a much lower level of inflation. Regaining control of inflation is going to be its key priority.

And in order to do so, it will have to press harder on the policy break. I would expect that next week, the Fed's still going to proceed with a 50 basis point rate hike. But there is increased chatter that there may be a 75 basis point increase at one of the upcoming meetings, or that the Fed may proceed with longer 50 basis point increments past the July meeting, which we know will likely be a 50 basis point rate hike meeting, too.

DAVE BRIGGS: Greg, if ever there's a time to buck conventional wisdom, forget about the fact that you took 75 off the table. Isn't this number irrefutable proof that we need a 75 point hike? Why not buck conventional wisdom and do it next week?

GREG DACO: Well, I think right now, we're very close to the meeting. And the Fed has been preparing markets for a 50 basis point rate hike. There will certainly be a lot of discussion during the FOMC meeting, where some participants will favor most likely a 75 basis point rate hike at the next week's meeting.

I do expect that the Fed will stick to 50 basis points, but what I expect to see as well is Fed Chair Powell talking about optionality, optionality to either prolong the 50 basis point incremental rate hikes or proceed with more rate hikes if there isn't the so-called considerable and clear evidence that inflation is moving in the right direction.

RACHELLE AKUFFO: And obviously, with this data that we saw coming out, people, of course, bringing back talk about recession versus stagflation. Talk about the risks that each of these come with and the likelihood that we're going to see these happen.

GREG DACO: I think we have to keep in mind that today, the US economy remains relatively robust. We still have a job market that's delivering a fairly robust amount of jobs on a monthly basis. We still have an environment in which job growth remains quite strong. But there are signs that inflation is starting to erode. Morale is starting to weigh on consumer spending trends.

And that will be a key concern for the Fed, because the Fed has to rebalance its inflation position, as well as prevent a downturn in economic activity. I don't think stagflation is really a risk for 2022. But I think increasingly, with inflation showing persistence and the economy likely to slow faster, stagflation could be very well a story for 2023.

SEANA SMITH: Greg, when it comes to Fed Chair Jay Powell's comments about inflation, I guess, how much does the market trust what he's saying, given the track record that we've seen over the last several months? And has he just completely lost the inflation narrative? Does the market just simply not trust him at this point?

GREG DACO: I think it's more a question of whether the next few rate hikes will be sufficient to cool inflation. We have a severe and lasting mismatch between demand that remains quite robust and supply that is struggling to keep up with that demand. We are going to see that these two elements are going to rebalance. But on top of that, we do need to see stronger Fed tightening to cool off some of the demand. Cooler demand and tightening financial conditions are going to be a feature of monetary policy being effective. It's not going to be a bug.

So the Fed is not going to back down at the first signs of a market correction or at the first signs of a slowdown in demand. That is what the Fed wants to do. It wants to prevent the risk of a wage inflation spiral or the US economy moving into a higher inflation regime. That's going to be the key focus of Powell and of the rest of the Fed, but it's going to be a very delicate exercise. And I think the more persistent the inflation appears, the more likely the Fed will press harder on the brakes and the more likely we are to be headed into a more significant slowdown.

RACHELLE AKUFFO: And I want to talk back about the consumer sentiment falling to that record low reading of 50.2% from May's reading of 58.4%. The University of Michigan's Consumer Sentiment Survey saying this level is comparable to the low point reached in the middle of the 1980 recession. But how concerning is that, given what we're seeing with consumer spending not quite being as grim as what we're seeing with consumer sentiment?

GREG DACO: Well, I think we have to understand what the different sentiment measures are showing. The University of Michigan's Consumer Sentiment measure is one that is heavily focused towards inflation. It's a measure that puts a lot of weight towards inflation, towards gas prices. And we've seen that gasoline prices have really been surging. So that's a key concern for US consumers.

At the same time, we're also seeing a robust labor market. So other confidence measures are actually pointing towards a better environment for overall spending. And we continue to see people spending. Consumers are still spending. Retail sales were still rising in the month of May. So that's quite encouraging overall. And I think what the Fed wants to see is actually some cooling of consumer spending dynamics. That's unlikely to happen before the end of the summer. We still expect a fairly strong travel season, as we've been talking about. We continue to see strong reservations for hotel, for airfares. And that's likely to continue to put upward pressure on service sector inflation.

DAVE BRIGGS: Long road ahead. Greg Daco, really appreciate your being here. Enjoy the weekend, sir. Thanks for your analysis.