As was widely expected, the Federal Reserve raised its policy rate by 75 basis points (bps) at the July meeting, taking the target rate range to 2.25%–2.5%. This is just below the Fed’s estimate for a neutral policy stance in the longer run (2.5%). At the press conference, Chair Jerome Powell said that “modestly restrictive” monetary policy is warranted by the current economic fundamentals, including elevated inflation, and mentioned that another outsize rate hike may be necessary at the next meeting in September in order to ensure monetary policy is restrictive. This would put the fed funds rate more in line with economic fundamentals, including elevated inflation, which argue for restrictive monetary policy.

The U.S. Treasury market rallied in response to the July statement and Powell’s comments, suggesting that markets were pricing in the risk of a more aggressive action in light of the recent inflation surprises. Indeed, inflation in much of the world has been more persistent than many central bankers anticipated. This appears especially true in the U.S., where, although U.S. headline inflation will likely move lower over the coming months due to the recent decline in global oil and agricultural prices, wage and rental market inflation – two areas where price trends tend to be more persistent – have actually accelerated (for example, see the Atlanta Fed’s Wage Growth Tracker).

How restrictive is ‘modestly restrictive’?

While there is uncertainty around the exact level of the fed funds rate that is consistent with the “modestly restrictive” guidance provided by Chair Powell, it seems clear that Fed officials don’t believe they have reached it yet, and that it could be closer to the 4% 2023 peak in the median rate forecast the Fed provided in June.

More broadly, Fed officials have struggled over the past few months with providing forward guidance for the path of interest rates, only to have inflation data surprises quickly make it stale. Nevertheless, we believe Chair Powell presented a balanced view on the distribution of risks, pointing to new evidence that growth is slowing while also underscoring the strength in the labor market, and what is increasingly likely to be more persistent inflation.

Chair Powell also reiterated his goal of achieving a soft landing – one where inflation comes down without a recession – but also suggested that the prospects for this outcome may be dimming. He also reaffirmed that restoring price stability as soon as possible is the Fed’s focus.

Near-term path of policy

Overall, there will be quite a bit of new information gained between now and the next Fed meeting on September 20–21. And while Chair Powell stopped short of endorsing another outsize rate hike, he left the door open that another 75-bp hike could be appropriate if inflation remains firm. The war in Ukraine and the geopolitical tumult compound uncertainty about the near-term path of growth and inflation. Similar to the other supply shocks that have occurred recently, these geopolitical shocks will have competing implications for the near-term path of Fed policy. At a minimum, adjusting policy from its neutral stance today to a more restrictive stance appears appropriate in light of recent data that suggest inflation is more persistent, and we believe the Fed is likely to move further in this direction.

Please visit our Inflation and Interest Rates page for further insights on these key themes for investors.

Tiffany Wilding and Allison Boxer are PIMCO economists and regular contributors to the PIMCO Blog.