San Francisco Fed President Mary Daly has voiced support for the central bank's decision to keep interest rates unchanged in July, but issued a stark warning that high inflation could become a more widespread issue, potentially requiring more aggressive policy action. Her comments highlight a deepening divide within the Federal Reserve over the path of inflation.
"I fully support the decision to hold rates steady in July," Daly stated at an event in Tokyo on Wednesday. She outlined two potential inflation scenarios: one where price pressures begin to cool, and another where they intensify and become more persistent. Each scenario, she argued, demands a different policy response. "The solution is to pay close attention to the incoming flow of information and be fully prepared to act," she said.
The Fed voted last week to hold rates steady, but the decision was not unanimous. Three policymakers dissented, advocating for a 25-basis-point rate hike, underscoring growing internal discord. While Daly is not a voting member of the Federal Open Market Committee (FOMC) this year, she participates in policy discussions.
Two Divergent Inflation Paths
Daly's remarks centered on two distinct possibilities for inflation. The first, which she considers the most likely, is that current price pressures from tariffs, rising energy costs, and an AI-driven investment boom are temporary and will fade on their own, allowing the Fed to maintain its current rate. The second, more worrying scenario, is that these pressures are spreading to other sectors of the economy, becoming broader and more entrenched. This scenario, she warned, is becoming increasingly plausible and would require more decisive Fed action.
Daly urged policymakers to monitor data closely for signs that the second scenario is materializing. "If we confirm the second scenario is becoming reality, then we have to ask: why continue with the old path of gradual rate hikes?" she said regarding potential future rate increases, adding that in such a case, it would be best to adjust policy as quickly as possible. She also cautioned that while long-term inflation expectations remain stable, a renewed rise following the 2022 inflation surge would make it significantly harder for policymakers to restore normalcy.
Growing Hawkish Tone Among Fed Officials
Daly's comments align with a broader hawkish shift among several Fed officials, who argue that further tightening is necessary to bring inflation back to the 2% target. Minneapolis Fed President Neel Kashkari, who was one of the three dissenters who voted for a rate hike in July, stated on Wednesday that the Fed should begin gradually raising rates to cool above-target inflation and avoid the need for more aggressive action later. He favors a gradual tightening path, potentially starting as early as September, though he did not commit to a specific timeline.
Kashkari's stance contrasts sharply with Philadelphia Fed President Patrick Harker, who also has a vote on the FOMC this year. Harker has argued that the current rate level is already providing a "moderate restraint" on the economy, supporting a wait-and-see approach. She indicated that voting to hold rates steady last week "was not a difficult decision."
Fed Governor Lisa Cook reiterated on Wednesday that she is prepared to support further rate hikes if inflation does not continue to slow. She warned that as the period of inflation above the 2% target lengthens, the Fed has less time to wait, as the difficulty of controlling inflation will increase. While she supported the July decision to hold, Cook stated she would be ready to act if there are no signs of easing inflation in the near term.
In contrast, Fed Chair Kevin Warsh has repeatedly emphasized the core stance of fighting inflation but has not clearly articulated how to address it, even suggesting that rate hikes may not be a necessary tool. This ambiguity has raised questions about his credibility on inflation, contributing to a surge in long-term U.S. Treasury yields last week to nearly two-decade highs, reflecting growing market concern about long-term inflation and fiscal sustainability.
Markets are now focused on the U.S. Labor Department's July non-farm payrolls report due on Friday for clearer guidance on the rate path. However, expectations for a rate hike cooled significantly on Thursday after the ADP private payrolls report, often seen as a precursor to the official data, showed a much-weaker-than-expected gain of just 44,000 jobs in July, far below the 75,000 forecast. According to the CME FedWatch Tool, the probability of the Fed holding rates steady in September stands at 45.6%, while the chance of a 25-basis-point hike is 54.4%. This is down from a peak of 73.6% for a September hike, as geopolitical tensions have eased and oil prices have fallen.
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