The Federal Reserve's “Big Three”: Inflation falls back to the baseline, and interest rates are at a reasonable level

The Zhitong Finance App learned that New York Federal Reserve Chairman John Williams gave a clear policy signal during an interview on Monday: he is still optimistic that inflationary pressure will gradually ease, but if inflation fails to fall as expected, the Federal Reserve will not hesitate to take action to raise interest rates. This statement comes after the Federal Reserve kept interest rates unchanged at 9 to 3 last week and three hawkish members voted against it, providing the market with the latest authoritative guidance on the path of monetary policy.

As the “top three” of the Federal Reserve and the chairman of the New York Federal Reserve with permanent voting rights, Williams's statement not only provided strong endorsement for the July standstill decision, but also subtly cooled the market's excessive interest rate hike bets.

Inflation judgment: The three major drivers are fading, and the 2028 2% target can be expected

Williams disassembled the current inflationary pressure into three core sources and gave judgments one by one:

First, the impact of tariffs has almost peaked. Williams believes that the effects of the Trump administration's previous tariff policy on inflation “have basically been transmitted to prices,” and that the additional impetus on the inflation rate will be drastically reduced in the next few months. He pointed out that the impact of “some major factors” that have boosted inflation over the past year and a half will clearly subside, and the “anti-inflationary forces” previously observed will reinvigorate.

Second, the effects of the Middle East conflict are expected to subside. Although the US-Iran conflict continues to push up energy prices, Williams believes that futures markets and experts still expect the conflict to eventually be resolved, and energy prices are expected to fall later this year. He said that at least in his benchmark forecast, the Middle East conflict will not continue to push up inflation in the second half of this year or next year. Once the situation is resolved and shipping returns to normal, improvements are likely to be very rapid.

Third, AI demand requires continuous observation. Although strong investment demand brought about by AI is driving up the prices of some commodities, Williams believes that it is not currently the main cause of inflation and classifies it as a variable that requires continuous observation.

Based on this, Williams maintained a judgment on the inflation outlook consistent with the FOMC meeting in June: the baseline forecast is still to achieve the 2% inflation target in 2028. He personally predicted that “inflation will begin to fall in the second half of this year, and it will fall further next year.”

Looking at the driving forces, falling housing costs, falling commodity inflation, and cooling inflation in core services will continue to drive inflation downward. Excluding energy and food prices, core inflation indicators should ease somewhat as the Middle East conflict no longer puts pressure on prices.

Policy position: Interest rates are “well positioned”, but interest rate hike options are “completely appropriate”

Williams reiterated that the current interest rate policy stance is “well-positioned” enough to push inflation back to the target. He “strongly supports” the FOMC's decision last week to keep the federal funds rate unchanged in the 3.50% to 3.75% range. He believes that the growth rate of the US economy is close to the trend level, the labor market is stable, and there is no sign of overheating.

Despite this, Williams also clearly warned, “If the economic development trajectory fails to pull inflation back to 2%, then it would definitely be appropriate to take action to get the economy back on track where it can achieve the 2% inflation target.” In particular, he emphasized that he is “very concerned about the performance of core inflation data in the next few months” and whether these figures are in line with the trend of the inflation rate approaching 2% and actually embarking on a continuous downward path.

The subtext of this statement is clear and restrained: inflation data will determine everything. If core inflation over the next few months shows no signs of steady progress towards 2%, interest rate hikes will quickly be put on the table.

Market game: Does not follow market pricing and does not accept “forward-looking guidelines”

Williams' interview also unleashed two important signals about the Federal Reserve's decision-making framework.

First, the Federal Reserve will not be kidnapped by the market. When asked if the Federal Reserve would adjust its policy due to market expectations, Williams clearly responded: “Absolutely not.” He stressed that the Federal Reserve will pay close attention to financial market developments, but “it must always independently complete its own analysis and do the proper research work.” This statement is an indirect response to the recent market betting heavily on an interest rate hike in September, and suggests that the Federal Reserve will not simply follow market pricing.

Second, forward-looking guidance is “out of date.” Williams pointed out that the current economic uncertainty is high, and clear forward-looking guidelines are no longer appropriate. When asked if the Federal Reserve will adjust its policy due to market expectations, Williams gave a clear negative answer. He pointed out that the Federal Reserve is adapting to the new Chairman Kevin Walsh's communication style — Walsh has gradually downplayed so-called forward-looking guidance and is no longer clearly releasing signals of future policy paths ahead of time.

AI and financial stability: normal fluctuations, controllable leverage

On AI-related topics, Williams gave a relatively optimistic judgment: AI is not a bubble. He believes that AI is a general technology with transformative potential, and current investment enthusiasm reflects the market's expectations for increased productivity and new business models. The recent fluctuations in the AI industry are “not surprising” and are a normal characteristic of a highly innovative and rapidly changing industry.

Second, leverage poses no threat. Regarding the risks that companies may bring about by borrowing money to invest in AI, Williams believes that the current level of corporate leverage “is far from what it was when the global financial crisis was triggered 20 years ago.” Most of these companies are highly profitable, so there is little concern that the current level of leverage poses financial stability risks.