Fed's Kashkari says there's a 40% chance interest rates need to go 'meaningfully higher'

Minneapolis Federal Reserve Bank President Neel Kashkari wrote in an essay published Tuesday that while he thinks it’s more likely than not the U.S. economy will achieve a "soft landing," there’s a 40% chance that interest rates will need to rise "meaningfully higher" to finally tamp down inflation.

Kashkari wrote that it’s possible that inflation "proves more entrenched than expected," in which case the Fed raising the benchmark federal funds rate by a quarter percentage point one more time only gets inflation down to 3% rather than its target of 2% — a scenario to which he attaches a 40% probability. The most recent data indicated that year-over-year inflation was 3.7% as of August. 

If inflation remains closer to 3%, he wrote that could indicate the U.S. economy entered a "high-pressure equilibrium" in which "households feel more confident about their economic futures and spend more than prior to the pandemic, keeping consumer demand strong and the economic flywheel spinning."

"In this scenario, the [Federal Open Market Committee] would then have to raise rates further, potentially going significantly higher to push inflation back down to our target," Kashkari wrote. "The case supporting this scenario is that most of the disinflationary gains we have observed to date have been due to supply-side factors, such as workers reentering the labor force and supply chains resolving, rather than monetary policy restraining demand."

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He added, "Services inflation has also been quite sticky and remains elevated to pre-pandemic levels. Once supply factors have fully recovered, is policy tight enough to complete the job of bringing services inflation back to target? It might not be, in which case we would have to push the federal funds rate higher, potentially meaningfully higher."

Kashkari estimated there’s a 60% probability that the Fed "potentially" raises the benchmark federal funds rate one more time later this year by a quarter of a percentage point and holds rates at that level long enough to get inflation down to its 2% target.

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"Substantial progress has already been made in reducing inflation while a healthy labor market has been maintained," Kashkari wrote. "In this scenario, the policy tightening we would soon achieve would prove enough to finish the job. Given the resilient economic activity we have observed, this looks increasingly like the proverbial soft landing that we are hoping to achieve."

He added, "I would have more confidence in the soft landing scenario if I were more certain that policy is truly tight relative to neutral today. The good news is that we don’t need to make this determination right now. We can observe the actual progress in bringing inflation down over the next several months to determine which scenario is the dominant one."

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There remains the risk that other economic shocks could throw policymakers’ plans into disarray, he noted. "Some of those shocks potentially could include a government shutdown, escalation of the war in Ukraine, extended domestic auto sector disruption, and spillovers from the slowing Chinese economy," Kashkari wrote.

The Federal Reserve, which skipped an interest rate hike at its meeting last week to assess how prior tightening impacts the economy, is scheduled to hold policy meetings two more times this year in November and December, when rates could be increased yet again.

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Kashkari is scheduled to appear Wednesday on FOX Business Network’s "Cavuto: Coast to Coast" with host Neil Cavuto, which airs at 12 p.m. ET.