David Kelly, Chief Global Strategist at J.P. Morgan Asset Management, argues the Federal Reserve currently has no need for additional rate hikes and should maintain its current interest rate stance. With growing evidence that the U.S. is struggling to form a sustained "wage-price spiral," inflation is expected to gradually decline. Overly tight monetary policy, however, risks delivering unnecessary shocks to the economy and financial markets.
Speaking after the release of the U.S. July Consumer Price Index (CPI) on Wednesday, Kelly stated, "The Fed absolutely should hold rates steady, and I actually believe they will." The latest data showed a relatively benign core inflation reading for July, which somewhat alleviated market concerns about further policy tightening. U.S. Treasury bonds held their gains following the data release.
Kelly believes U.S. inflation is already showing a clear trend of gradual cooling, driven by three main factors. First, the base effects from previous tariff hikes are fading, which will likely reduce their year-over-year contribution to inflation. Second, optimistic expectations for an end to the war in Iran are pushing oil prices lower, potentially easing energy price pressures further. Third, U.S. wage growth continues to lag behind inflation, meaning rising wages are not creating a sustained impetus for companies to raise prices.
Kelly pointed out that while U.S. inflation remains at an elevated level, it lacks the momentum for sustained upward movement, making it difficult for price pressures to become entrenched. He stated the Fed does not need to try to accelerate the decline in inflation through further rate hikes. "This is like an injury; it can only heal slowly. If you try to speed up the process, you might actually make things worse," he said. In his view, as long as wages do not react persistently and strongly to price increases, the U.S. is unlikely to form a genuine wage-price spiral, making a self-correcting, gradual decline in inflation the most likely scenario.
Kelly also criticized the Fed's recent communication strategy, arguing that the upcoming speech by Fed Chair John Warsh at the end of August's Jackson Hole Global Central Banking Symposium will be a significant moment. Since becoming Fed Chair in May, Warsh has significantly downplayed forward guidance, aiming to reduce the Fed's clear signaling of its future policy path and allow financial markets to price more based on economic data. Kelly described this direction as problematic, stating the Fed's attempt to reduce communication with the market has "gone down the wrong path." He expects that with the latest inflation data providing a positive signal, Warsh may need to moderate his previously hawkish tone in his Jackson Hole speech and acknowledge that the U.S. has made some progress in reducing inflation.
Regarding whether the Fed could use rate hikes to strengthen its credibility in fighting inflation and thereby stabilize long-term Treasury yields, Kelly called this a "very close call." Markets have recently worried about whether the Fed has sufficient policy credibility after inflation has run above the 2% target for several years. Theoretically, if rate hikes bolster investor confidence in the Fed's determination to control inflation, long-term inflation expectations and term premiums could fall, exerting some restraint on long-end Treasury yields. However, Kelly believes that compared to rate hikes, Quantitative Tightening (QT) may be a more dangerous policy tool, as shrinking the Fed's balance sheet puts more direct upward pressure on long-term rates. Combining rate hikes with intensified QT could increase the risk of financial market instability.
Kelly specifically warned that financial markets currently carry a high degree of leverage. Therefore, even a limited rate hike by the Fed could have a market impact that exceeds the policy move itself. If short-term rates rise further, investors might be more inclined to shift funds into safe assets like cash and short-term Treasuries, thereby weakening the appeal of stocks and other risk assets. Kelly noted that if the Fed chooses to raise rates, higher short-term rates could strengthen investors' desire to move to safe assets, "which could undermine the impetus for the market's rally."
Overall, Kelly believes U.S. inflation is moving slowly but steadily in the right direction. With no mechanism for sustained wage-driven price increases, the Fed has no reason to rush into further tightening. Compared to forcing a faster decline in inflation through rate hikes, maintaining current interest rates and allowing existing inflationary pressures to gradually dissipate is likely the lower-risk policy choice.
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