Exclusive-Fed's Musalem says oil shock likely to keep core inflation near 3%, rates on hold for some time

WASHINGTON, April 15 (Reuters) - High oil prices are likely to keep underlying inflation nearly a percentage point above the Federal Reserve's 2% target for the rest of this year, with the U.S. central bank likely needing to leave interest rates unchanged, St. Louis Fed President Alberto Musalem said on Wednesday.

"It's likely we're going to see some pass-through of oil prices onto core inflation," with that underlying measure of price increases ending the year "a shade below 3, maybe around 3" percent, versus the Fed's 2% target, Musalem said in a Reuters interview, with risks that it could even be higher.?

Musalem said the central bank could leave its policy rate in the current 3.50%-3.75% range "for some time," watching data on inflation, jobs and the economy in coming months, a view shared by many of his colleagues.

While the Fed had been poised to cut rates this year, the outbreak of the war in the Middle East and the subsequent spike in oil prices has shifted the outlook, with investors expecting the Fed to be on an extended pause while monitoring the impact of the conflict.

The Fed sets its 2% inflation target against the Personal Consumption Expenditures Price Index, which was increasing at a 2.8% annual rate as of February. The separate "core" measure, however, which is considered a better gauge of future inflation by excluding energy and other volatile commodity-based costs, increased at a faster 3% rate in February and is anticipated to rise to 3.2% in March.

The oil shock, with Brent crude prices still at about $95 a barrel versus around $70 before the start of the U.S.-Israeli war with Iran, has carried over quickly to gasoline prices, but also promises higher shipping and travel costs, and even higher food prices, as fertilizer and similar inputs escalate.

The news on the prices front isn't all bad, Musalem said, with the lingering impact of last year's tariff increases likely to fade in the current quarter, and housing price inflation also ebbing.

But with oil pushing in the other direction, and inflation on an array of services also high, Musalem said he'd be open to rate hikes if inflation starts to move higher and threatens to pull inflation expectations with it.

Monetary policy right now "is in a good place, and I think it's probably going to be appropriate to maintain policy at this level for some time," Musalem said. "We need to see all components of inflation come down in a balanced way. Right now, we have housing doing most of the work. Goods moving the opposite direction, and core?non-housing services still sticking."

If it gets worse "at that point, the risk of de-anchoring inflation expectations would become relevant. Right now, inflation expectations medium to long term are very anchored, but they would become relevant, and at that point it might be appropriate to raise rates," he said.

TRICKY SITUATION FOR WARSH

While Musalem said any developing risks to the job market could also bring rate cuts into play, markets since the start of the war have seen a fading chance for looser monetary policy.

The outlook is for the Fed to stay on hold until well into next year, a potentially ticklish situation for Fed chief nominee Kevin Warsh as he awaits Senate confirmation, with President Donald Trump and other administration officials voicing confidence that his arrival at the central bank will mean lower borrowing costs. Warsh's confirmation hearing has been set for April 21.

To get that outcome, however, Warsh will have to convince other members of the Fed's Board of Governors as well as some of the central bank's regional reserve bank presidents that it's the right thing to do. Musalem is not among the five regional presidents who vote on interest rate policy this year. But other colleagues share his inflation worries, with an increasing number at the Fed's March 17-18 meeting saying they'd be open to noting the possible need for rate hikes in the central bank's policy statement.

The Fed is expected to keep its policy rate on hold at its April 28-29 meeting while debating internally whether to add more hawkish language to its statement.

Oil markets are "the third negative supply shock in 12 months," Musalem said, along with rising tariff rates and tougher immigration rules, putting both the inflation outlook at risk as well as that of the job market through a likely blow to growth.

Musalem said he felt it is too early to see an impact on overall consumption, though he anticipates the unemployment rate might rise slightly. Growth, he feels, will be slower this year, though still in the range of 1.5% to 2%.

"There are two-sided risks to rates," Musalem said. "Risks have increased on both sides of the mandate, towards higher inflation and towards the weaker labor market ... If you add the two things together, policy is well positioned where it is currently."

(Reporting by Howard Schneider; Editing by Paul Simao)