Fed Chatter Hints of Lingering Upside Risks to Interest Rate Outlook

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Federal Reserve (Fed) policy and the financial conditions that it influences have shifted in a tighter direction at a rapid pace since June last year but several influential members of the Federal Open Market Committee (FOMC) suggested this week that markets may yet have to move further in the months ahead.

Financial markets already expect the Fed to raise its interest rate by 0.50% following each of the June and July FOMC meetings, which lift the Fed Funds rate close to 2% and its highest since 2019.

In addition, rates or prices in the overnight index swap market were suggestive this week of expectations among investors and traders that the bank could be likely to raise the benchmark further and as far as 2.75% by year-end. 

But remarks from several FOMC members published this week indicated that even these expectations may be too low if the Fed is to succeed in its efforts at bringing inflation down to the bank's 2% average target, from 8.5% in April.

“In my view, with inflation as elevated as it is, the funds rate will probably need to go above its longer-run neutral level to rein in inflation. But we cannot make that call today because it will depend on how much demand moderates and what happens on the supply side of the economy. So, we need to continue monitoring economic and financial developments closely,” Federal Reserve Bank of Cleveland President Loretta Mester said this week. 

Above: Expectations for the midpoint of the 25 basis point wide Fed Funds rate range as implied by overnight index swap market. Click image for closer inspection.

Mester characterised these inflation rates as reflecting an imbalance between the "strong aggregate demand" whipped up by the economy's exit from a coronavirus-induced hibernation and "constrained aggregate supply" resulting from a variety of factors including the stop-start implementation of restrictions elsewhere in the world. 

"Some of our business contacts have characterized the situation as akin to Whac-A-Mole. As soon as they figure out how to solve a problem in one part of their supply chain, a problem arises in another part," she said.

"This has meant that the supply chain disruptions have lasted a lot longer than businesses expected," she added

Elsewhere in Fed chatter this week Vice Chair of the board Lael Brainard indicated that current market pricing for interest rates is the least that should be expected, while board colleague Christopher Waller came across almost as hawkish as Federal Reserve Bank of St Louis President James Bullard. 

“We’re certainly going to do what’s necessary to bring inflation back down. We are starting from a position of strength. The economy has a lot of momentum. The other factor that I think is very positive is that business balance sheets, household balance sheets, start this process from a very healthy position,” Vice Chair of the Federal Reserve Board Lael Brainard said on Thursday. 

“On inflation I am going to be looking to see a consistent string of decelerating monthly prints on core inflation before I am going to feel more confident that we’re getting to the kind of inflation trajectory that is going to get us back to our two percent goal. In terms of our tools, they are very effective at cooling aggregate demand,” she said in an interview with CNBC News.

Previously, Federal Reserve Bank of St Louis President James Bullard had said on Wednesday that inflation in the U.S. is comparable to levels seen in the 1970s and warned that U.S. inflation expectations could become unmoored without credible Fed action.

James Bullard’s concern is that without this the Fed would risk inviting a new regime of high inflation and volatile economic outcomes.  

“This situation is risking the Fed’s credibility with respect to its inflation target and associated mandate to provide stable prices in the U.S.,” he said.

“Forward guidance on these dimensions is helping the Fed move policy more quickly to the degree necessary to keep inflation under control,” he added.

All of this came after Fed Board Governor Christopher Waller said in a virtual presentation to the Institute for Monetary and Financial Stability (IMFS) at Goethe University in Frankfurt, Germany, implied that he too could favour what would be a similar stance to that of James Bullard.

“I support tightening policy by another 50 basis points for several meetings. In particular, I am not taking 50 basis-point hikes off the table until I see inflation coming down closer to our 2 percent target. And, by the end of this year, I support having the policy rate at a level above neutral so that it is reducing demand for products and labor, bringing it more in line with supply and thus helping rein in inflation,” he said in one part. 

“This is my projection today, given where we stand and how I expect the economy to evolve. Of course, my future decisions will depend on incoming data. In the next couple of weeks, for example, the May employment and CPI reports will be released. Those are two key pieces of data I will be watching to get information about the continuing strength of the labor market and about the momentum in price increases,” he added.