Another Fed rate hike? Inflation keeps the option alive

Dallas Federal Reserve President Lorie Logan has issued a new warning to investors that the battle against inflation might not be over yet.

On Thursday, she pointed out that the Federal Reserve (Fed) may have to be stricter with its monetary policy if inflation does not bring down its numbers. According to her, “modestly higher” interest rates could help balance inflation and economic risks, meaning a rate hike shouldn’t be ruled out.

Logan’s remarks fuel an increasing discussion within the US central bank regarding the duration of the high cost of borrowing. Even though inflation has declined from its peak, decision-makers are not fully persuaded that inflation is gradually approaching the Fed’s goal of a 2% rate.

The ambiguities in the US economy have implications that stretch further than its borders. Given that the dollar is the leading global reserve currency, any interest rate changes that occur in the US also impact financial markets globally, including share prices and cryptocurrencies and borrowing costs in many developing countries.

According to its latest Monetary Policy Report submitted to Congress on July 10, the Federal Reserve claimed that inflation is still up due to a variety of factors, including tariffs, rising energy prices as a result of geopolitical disputes, and increased investments in artificial intelligence. Moreover, the strong labor market does not prevent the Fed from raising interest rates.

Signals that consumers fear inflation persist. According to the Survey of Consumer Expectations published by the New York Federal Reserve for June, consumers’ expectations for inflation over the upcoming year increased from 3.6%, the highest rate since September 2023. Expectations regarding inflation over the next three years also increased to 3.3%, while remaining unchanged for the following five years at 3.0%. Therefore, one may assume that some families expect prices to increase quicker than the Federal Reserve would like to see.

Fed officials send mixed signals

Logan’s remarks were among a series of observations made by senior leaders of regulatory agencies this week, but not all of these observations had consistent content.

Logan pointed out that taking action now is better than later to prevent inflation from taking hold; otherwise, if action is postponed for too long, a more severe policy would be necessary later.

Philip N. Jefferson, the Vice Chair of the Federal Reserve, was much more cautious in his comments. During a speech on July 16, he said that the current policy is “well positioned”, but at the same time cautioned against jumping to conclusions based on a good inflation report. Jefferson noted that in case of any changes in the inflation numbers in the future, the authorities would be prepared to increase the interest rate.

Fed Chair Kevin Warsh has taken a very cautious approach. He has said that in the end, bringing prices back under control is the most important thing for the central bank, but he has stopped short of saying whether there will be more increases in interest rates.

Overall, the statements show that the central bank is striving for a common objective, although the exact path to attain that objective is unclear. Investors will also have to take this uncertainty into account in the long run.

Markets still expect easing

Notwithstanding the Fed’s prudent language, traders remain optimistic about falling interest rates in the future.

According to the Fed’s June Summary of Economic Projections, policymakers may keep interest rates high until they are confident inflation is returning to 2%. Nevertheless, futures markets still indicate that traders expect them to start going down gradually, although the forecasts were made less aggressively than before the recent inflation data and the hawkish remarks from Fed officials.

This disconnect creates risk for the markets any time officials speak more hawkishly than anticipated. In fact, for example, comments from Logan last week sent yields up in the Treasury market as traders rethink how the Fed might be forced to act if inflation were to level off.

The consequences for the world economy go far beyond the monetary policy of the United States. Higher interest rates usually strengthen the dollar, increase the cost of borrowing and tighten credit conditions. This can cause additional pressures on emerging market economies, at the same time creating pressure on technology stocks and cryptocurrencies that had previously benefited from hopes for a fall in borrowing costs.

In anticipation of the upcoming monetary policy meeting of the Federal Reserve, market participants are bound to focus on the inflation data along with the statements of officials like Logan, Jefferson, and Warsh to get clues about the fact whether the policymakers have reached a point of consensus or whether the discussions about interest rates have just begun.

If you're reading this, you’re already ahead. Stay there with our newsletter.