Fed Officials See Interest Rate Hike as ‘Necessary’ If Inflation Doesn’t Ease Soon

Federal Reserve policymakers see an interest rate hike as likely if inflation does not ease in the coming months, according to newly released meeting minutes.

Minutes from the Federal Open Market Committee meeting held in Washington, DC, on July 28 and 29 suggest that there is growing acceptance on the panel that an increase to overnight interest rates may become necessary.

"Many participants assessed that policy tightening would likely be necessary if inflation did not decline," the minutes state. "Some participants commented that financial conditions might not currently be sufficiently restrictive to facilitate a return of inflation to 2%."

At the meeting, the majority of the 12-member panel voted to leave rates unchanged at a top range of 3.75%, where they have remained since January. But Fed Chairman Kevin Warsh, who called for lower rates before taking office in May, faces a rising chorus of rate hike calls from more hawkish colleagues.

Chief among them was Cleveland Fed President Beth Hammack, who, along with Dallas Fed President Lorie Logan and Minneapolis Fed President Neel Kashkari, voted to raise rates at last month's meeting.

"A few of the participants who favored raising the target range for the federal funds rate at this meeting judged that doing so would likely help forestall the need for a steeper and potentially more costly sequence of tightening moves at a later stage," the meeting minutes state.

The release of the meeting minutes on Wednesday was highly anticipated by market observers, as they shed light on the FOMC's split decision at a time when the Fed is scaling back its public communications.

Warsh has advocated for a less chatty central bank, arguing that policymakers should speak to markets primarily through their monetary policy decisions, rather than through statements, press conferences, and forecasts.

The Fed chairman has also proposed scaling back the number of policy meetings to six times a year, down from the current eight. That proposal, which has yet to be adopted, would take effect next year.

For now, the new minutes suggest there is broader support for an eventual rate hike than July's split decision might suggest, and that the main question is not if, but when, the Fed raises rates.

"I am not surprised there's more support for a hike than the vote suggested," says Realtor.com® senior economist Jake Krimmel. "It will be interesting to see whether bond and prediction markets react to the Fed minutes themselves in the absence of any real discussion from the chairman on the Fed's reaction function."

Krimmel notes that recent inflation reports showed a slowdown that could give the Fed enough reason to hold off on hiking rates. The consumer price index registered 3.4% in July, down from 3.5% in June.

"Bottom line, though: The FOMC is more divided than any meets the eye. And this is happening while it's quieter than any time in recent memory," the economist says.

What's next for Fed rate policy

The FOMC will meet three more times this year, in September, October, and December. Because the October meeting falls just days before the midterm elections, policymakers may be reluctant to initiate a new round of rate increases at that meeting, to avoid the appearance of playing politics.

That leaves the vote on Sept. 16 as the last opportunity for action on interest rates before a potential three-month blackout on initiating rate hikes. (The Fed can, and does, change rate policy outside of regularly scheduled meetings to address crisis situations.)

Currently, bond markets estimate a roughly 30% chance that Fed officials will vote for a quarter-point rate hike in September, which would take rates to a range of 3.75% to 4.00%. Odds of a continued pause hover close to 70%.

However, much could change in the coming month. There will be two key inflation reports before the September vote, as well as a jobs report, which could change the outlook for interest rates significantly.

Importantly, the Fed controls the short-term interest rates used for overnight lending between commercial banks, while long-term rates for mortgages are set by the free market.

Mortgage rates have been rising since March, as the Iran war drove global oil prices up, raising the threat of inflation and making Fed rate hikes more likely.

Significantly, there is a growing sense in markets that economic growth will remain robust at current interest rate levels, which would have been considered restrictive a few years ago. As well, there is concern about the rising federal debt, which topped $40 trillion this week for the first time ever.

Those trends may signal a "new normal" of higher interest rates, at least compared to the lengthy period of ultralow rates seen after the Great Recession.

That would come as a bitter pill for President Donald Trump, who has advocated for dramatically lower Fed rates and selected Warsh for the chairman job in the hope he would deliver them.

Trump has said he believes the Fed should lower interest rates, but has remained supportive of Warsh, while reiterating on Wednesday that he wants to see interest rates "come down."

"You know, in the old days…when we announced good numbers, interest rates would go down," said Trump. "And the theory was: Because the asset value became so good. But now, when we announce good numbers, which we are doing all the time, they keep driving the interest rates up because they are so afraid of inflation."