Federal Reserve Bank of Philadelphia President Anna Paulson said Tuesday she is keeping an open mind on interest rates and will be guided by how underlying inflation evolves.
In an essay published Tuesday, Paulson sketched two distinct scenarios for how current policy settings might work through the economy and influence inflation.
In the first scenario, she wrote, a continued pattern of improving inflation readings together with steady price expectations would signal that policy is "mildly restrictive." Under that condition, Paulson said, the existing stance of interest rates should be sufficient to nudge inflation back toward the Federal Reserve's 2% objective within what she described as an acceptable time frame.
The alternate scenario posits that current policy may fall short of being restrictive enough to drive inflation to 2%. Paulson emphasized that inflation has been above the Fed's target for more than five years and that measures of underlying inflation have only edged down modestly over the past year. After adjusting for what she considers temporary influences from tariff increases and energy prices, she estimated that underlying inflation is running in a range between 2.4% and 2.8%.
Paulson set out the specific signs she will watch to determine which of the two scenarios is taking shape. Those signals include additional months of improving inflation data, business reports that are consistent with a path back to 2% inflation, and evidence that pressures linked to tariffs, energy, and investments in artificial intelligence remain contained.
On the most commonly reported measures, headline PCE inflation eased to 3.7% in June. The unemployment rate stood at 4.2%.
Policy has been steady recently: Fed officials left interest rates unchanged for the fifth consecutive meeting last week. The decision was not unanimous - three policymakers dissented, arguing in favor of a quarter-point increase on the grounds that a modest tightening now would lower the risk of requiring larger hikes later.
Summary
Anna Paulson remains undecided on the future path of interest rates and will look to underlying inflation trends—adjusted for temporary tariff and energy effects—to decide whether current policy is sufficiently restrictive to return inflation to 2%.
Key points
- Paulson outlined two scenarios: one where policy is mildly restrictive and sufficient, and one where it is not restrictive enough.
- She estimates underlying inflation at 2.4% to 2.8% after removing temporary tariff and energy effects.
- Headline PCE inflation was 3.7% in June and unemployment was 4.2%; Fed officials kept rates unchanged, with three dissenters favoring a 25-basis-point hike.
Risks and uncertainties
- Underlying inflation may prove more persistent than current measures suggest, affecting inflation-sensitive sectors such as consumer goods and services.
- Tariff and energy price pressures, if not contained, could complicate the Fed's path to 2% and influence interest-rate-sensitive markets including bonds and credit.
- Disagreement among Fed policymakers on the need for further rate hikes introduces uncertainty for financial markets and borrowing costs.