Fed officials fret over inflation risk, weigh rate hikes

The leanest readout of a Federal Reserve policy meeting in years still made clear how concerned U.S. central bank officials remain about inflation and how they will likely react with interest rate hikes if it remains too high much longer, putting emphasis on a coming spate of price reports against a backdrop of renewed hostilities in the Middle East. The minutes of the June 16-17 Federal Open Market Committee meeting showed an even divide between one body of policymakers largely content to leave rates where they are and another viewing higher borrowing costs as the appropriate path.

The crux of the readout, released on Wednesday, was around a discussion of scenarios and possible policy responses, the clearest of which appeared to be that in an adverse scenario of persistent, broadening inflation, most Fed officials would be ready to respond with higher rates, while in a favorable scenario of falling inflation, most of them would ‌be happy to hold rates steady or ⁠eventually cut ⁠them. "I do think (the minutes) showed that richness of these scenarios," New York Fed President John Williams said on Thursday during a conference at his regional Fed bank. "There are certain parts of the inflation outlook that are probably maybe a little bit more benign, say on the tariffs, maybe on the energy prices, depending how that plays out. But there are other scenarios where inflation is more persistent and stays higher, which would ... call for tighter monetary policy. I think that's the right way to think about it."

"I think that the minutes actually captured a collective reaction function in a way, even though it's not designed to do that," he said.


Whether the spare nature of the latest minutes reflected the influence of new Fed Chairman Kevin Warsh, who is spearheading a review of the central bank's communications among other things, was a focus of debate among economists. Several noted that a section on risk management that had been a staple under former Fed Chair Jerome Powell was absent. Still, some saw obvious signals.

"The minutes provide the clearest articulation yet of the Fed's reaction function under Chair Warsh, marking a shift from broad risk-management language toward explicit scenario-based policymaking," Gregory Daco, chief economist at EY-Parthenon, wrote shortly after the release of the document. "Our interpretation is that the Committee wants markets ⁠to recognize that ‌additional tightening remains a live possibility if inflation proves more persistent," he said, but that easing inflation would leave a majority comfortable to stay on hold. In a follow-up comment to Reuters on Thursday, Daco said: "What struck me was that this scenario discussion was not framed as a risk-management strategy. Rather, it aimed to show consensus amongst policymakers as to their reaction function across different scenarios, even if there is an even split between ⁠the two views."

FEW, SEVERAL, MOST, 'MILQUETOAST'

The June meeting minutes gave so little color on the likely path of interest rates that one economist described them as a "milquetoast" description of the projections every policymaker but Warsh had submitted for the meeting. In the minutes from the April 28-29 meeting, "several" participants felt a rate cut would likely be appropriate "once there are clear indications that disinflation is firmly back on track or if solid signs emerge of greater weakness in the labor market." By contrast, "a majority" of them felt that "some policy firming would likely become appropriate" if inflation stayed above the Fed's 2% goal. The takeaway was plain: the rate-cut camp was thinning as policymakers expressed more openness to a rate hike.

The rate-path "dot plot" chart that was published at the end of last month's meeting showed that transformation was complete, with policymakers now seeing rate hikes as far more likely than cuts.

But it was tough to discern that outlook from the latest minutes, which described two evidently overlapping groups: "most" participants seeing scenarios in which inflation would ease soon, in which case "almost all" would support keeping rates on hold or cutting them; and "most" seeing scenarios where inflation remains elevated, in which case "almost all" would support policy firming.

"The short version is: if inflation comes down, rates could come down, but if inflation doesn't come down, rates could go up!" was how Michael Feroli, chief U.S. ‌economist at J.P. Morgan, summed up the policy outlook in an email titled "Milquetoast minutes reflect divided dots." The June meeting minutes indicated policymakers broadly remain in the first camp, noting that "participants anticipated that inflation would remain elevated in the near term and then begin to decline as the effects of tariffs and energy price increases wane and other supply disruptions related to the closure of the Strait of Hormuz diminish." The April meeting minutes contained no overarching expectation for inflation to fall. "This suggests somewhat greater confidence that temporary disruptions ⁠would fade" and that inflation would be lower in the future, Omair Sharif, the founder and president of forecasting firm Inflation Insights, wrote in a note. The minutes released this week also omitted the comment from the April meeting minutes that a "vast majority" of participants felt that inflation would take longer to return to 2% than previously expected. Finally, while the April meeting minutes said that "most" participants felt measures of long-term inflation were stable, a "majority" felt so in the minutes from the June meeting. "This clearly seems more dovish," Sharif wrote.

INFLATION DATA AHEAD

The June meeting minutes underscored the importance of incoming inflation data on the rate-path decision, particularly as U.S. hostilities with Iran, a key driver of the recent run-up in energy costs and other commodity price pressures, flared again this week after a run of relative calm.

Next week brings the reports on consumer and producer inflation for June, which may reflect some easing of pressures as oil prices eased back to near their pre-war levels amid ceasefire negotiations. Still, with the Consumer Price Index having risen 4.2% for the year through May and policymakers concerned about signs of widening inflation in the services sector, it may still be some time before Fed officials are ready to lower their guard.

"I've spent much of my career as a policymaker talking about being data-dependent," Williams said on Thursday. "I have not changed. I still think we need to be data-dependent." Next week will also feature Warsh's first appearance before Congress since formally taking the Fed's reins in late May. He could face heated questions from Democrats in particular about what the central bank intends to do to contain inflation.