Dallas Fed president Lorie Logan said Monday that the Fed may have to do more to cool inflation if the economy continues to surprise to the upside, pushing up long-term bond yields.
“If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate,” Logan said in a speech in Dallas at the National Association for Business Economics annual meeting, pointing to the recent spike in long-term bond yields.
“However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more.”
Logan said she expects the Fed will need “continued restrictive financial conditions” to bring inflation down to the Fed’s 2% target in a timely way.
In trying to understand what’s driving the latest movements in yields, Logan says her back-of-the-envelope estimates suggest that more than half of the total increase in long-term yields since the July Fed meeting reflects rising term premiums.
The term premium is the amount by which the yield on a long-term bond is greater than the yield on shorter-term bonds. The premium reflects the amount investors expect to be compensated for lending for longer periods.
Logan noted the economy has shown surprising resilience over the past year in the face of sustained real interest rates — rates adjusted for inflation — north of 1.5%.
“I’m starting to take some signal from that resilience, not only about the rates needed to restore price stability in the next few years but also about the rates that will need to prevail to sustain price stability and maximum employment over a much longer horizon,” she said.
Logan noted that the bond market could do some of the Fed’s work for it by cooling the economy. She expects that as the Fed continues to shed Treasuries from its bloated balance sheet, it means more investors will be required to hold Treasuries instead of the Fed, contributing to higher yields.
The bond market is closed for Columbus Day on Monday, but the yield on the 10-year Treasury has soared by nearly 80 basis points since August, nearly knocking on the door of 5% Friday — the highest level since 2007.
Logan said that while there was welcome progress on inflation, monthly inflation data have been somewhat uneven, and it’s still too soon to say with confidence that inflation is headed to 2% in a sustainable and timely way.
And while the job market isn’t as hot as it was a year ago, it remains very strong overall. The US economy has been adding more than 250,000 jobs per month, more than enough to keep pace with trend growth in the labor force, according to Logan.
The Fed voted to hold rates steady in its September policy meeting but kept the door open for one more rate hike. Officials are heavily data dependent. A surprisingly strong jobs report for the month of September has markets toying with higher odds of another rate hike if another closely watched measure of inflation this week comes in hot.