Fed's Daly: Supports keeping interest rates unchanged in July but warns of the risk of inflation spreading.

After the July interest rate meeting, internal policy disagreements within the Federal Reserve have intensified, and stubborn inflation has again become a significant concern for policymakers. Mary Daly, President of the San Francisco Fed, stated on Wednesday that she supported the Fed's decision last week to keep interest rates unchanged but warned that high inflation could be a broader issue requiring more aggressive measures from policymakers. "I fully support the decision to maintain interest rates in July," Daly said at an event in Tokyo on Wednesday. She believes there are two possible scenarios for inflationone where inflation begins to cool down, and another where price pressures continue to escalate, each requiring different policy responses. "The solution is to closely monitor the flow of incoming information and be fully prepared to take action," she stated. Last week, Fed officials voted to keep interest rates unchanged, but three policymakers cast dissenting votes advocating for a 25 basis point hike, indicating a deepening split within the Fed. Daly is not a voting member of the Federal Open Market Committee (FOMC) this year, but she will participate in policy discussions. Fed officials have differing opinions on the risks posed by inflation pressures and how to address them. Officials, including Daly, still believe that the shocks from tariffs, soaring energy prices, and the surge in AI investments may be localized phenomena that will eventually subside. In contrast, other officials argue that inflation in these areas has spread to other sectors of the economy. Two Inflation Scenarios Daly outlined two possible paths for inflation during her speech. The first scenario is that inflation is temporary, allowing the Fed to maintain interest rates. This is the scenario Daly believes is most likely. However, she cautioned that the second scenario is becoming increasingly likely, where rising tariffs, escalating energy costs, and sustained investment in AI lead to increased prices. In this case, inflation would be more widespread and persistent, necessitating more aggressive action from the Fed. Daly stated that policymakers should closely monitor the likelihood of the second scenario occurring and keep a close watch on relevant data in the coming weeks. "If the second scenario is confirmed to be materializing, then we must ask: why continue down the old path of gradual rate hikes?" Daly said when discussing potential rate hike options, adding that it would be best to adjust policy as soon as possible in that situation. Daly also warned that while long-term inflation expectations are stable for now, if inflation expectations rise again following the surge in 2022, policymakers may face greater challenges in restoring normalcy. Fed Officials Release Hawkish Signals Notably, several Fed officials have begun to send hawkish signals, asserting that to bring inflation back down to the 2% policy target, further tightening of monetary policy will be necessary in the future. Neel Kashkari, President of the Minneapolis Fed, stated on Wednesday that the Fed should begin gradually raising interest rates to reduce inflation, which remains above target, and to avoid being forced into more aggressive hikes in the future due to further entrenchment of inflation. He favors a gradual tightening path, which could begin as early as September, although he did not commit to a specific timetable. At the FOMC meeting last week, Kashkari was one of the three dissenters who supported a 25 basis point rate hike. The remaining nine voting officials supported keeping rates unchanged. Kashkari's stance sharply contrasts with that of Philadelphia Fed President Patrick Harker. Harker, who also has voting rights on the FOMC this year, previously stated that the current rate levels already constitute a "modest restraint" on the economy and thus supported remaining on hold while waiting for more data. Harker also said that last week's vote to maintain rates was "not a difficult decision" for him. Fed Governor Lisa Cook reiterated on Wednesday that if inflation does not continue to slow in the future, she is prepared to support further rate hikes. She warned that as the time inflation remains above the 2% target prolongs, the Fed may not have much time left to continue waiting, or it will become increasingly difficult to control inflation in the future. Cook indicated that although she supported keeping rates unchanged at the July meeting, if there are no signs of inflation continuing to decline in the near term, she would be prepared to take action. It is noteworthy that, despite Fed Chair Kevin Warsh repeatedly emphasizing the core stance against inflation, he has not clearly outlined how to respond to inflation and even suggested that rate hikes might not be necessary, raising questions among investors about his anti-inflation credibility. Warsh's ambiguous statements led to U.S. long-term Treasury yields rising to their highest levels in nearly two decades last week, reflecting increased market concerns over long-term inflation and fiscal sustainability. Currently, the market is awaiting the U.S. Labor Department's July non-farm payroll report, due on Friday, for clearer guidance on the issue of rate hikes. It is worth noting that the "little non-farm" ADP data released on Thursday significantly fell short of expectations, cooling rate hike expectations dramatically. The data showed that the U.S. private sector added only 44,000 jobs in July, well below the market expectation of 75,000, indicating a cooling of the job market that begins to ease the Fed's rate hike pressure. CMEs FedWatch tool indicates that the probability of the Fed keeping rates unchanged in September is 45.6%, while the probability of a cumulative rate hike of 25 basis points is 54.4%. Previously, the probability of a 25 basis point hike in September had risen as high as 73.6%, but expectations have cooled with the easing geopolitical situation and falling oil prices.