High inflation and strong recovery require Fed interest rate increases: Bostic

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High inflation and strong recovery require Fed interest rate increases: Bostic

WASHINGTON, January 11, Reuters - High inflation and a strong recovery will require the Federal Reserve to raise interest rates at least three times this year, beginning as soon as March, and warrant a rapid rundown of Fed asset holdings to draw excess cash out of the financial system, according to Atlanta Fed President Raphael Bostic.

Bostic said in an interview on Monday that there is a risk inflation will likely be elevated for an extended period of time and we need to respond directly, clearly and aggressively. If things continued as they are March, it would be a reasonable possibility that interest rate increases would be necessary for the first of what would be a series of interest rate increases to offset inflation running well above the Fed's 2% target.

He said that he does not believe that the explosion in new coronaviruses will derail the recovery, but to the contrary he feels that inflation will increase further and require a fourth quarter-point rate increase in 2022 than that it slows and allows the Fed to relax.

He said the Fed's turn towards inflation fighting was reflected in the December meeting where officials accelerated their plans to raise interest rates and begin to withdraw back their holdings of U.S. Treasury bonds and mortgage-backed securities accumulated during the epidemic.

Bostic said in detailed remarks about the management of the Fed's balance sheet that the central bank should be aggressive there as well as allowing its holdings to decline by at lease $100 billion a month, and with plans to pull at least 1.5 trillion out of financial markets that he considers pure excess liquidity. From 2017 to 2019 when the Fed was shrinking its balance sheets years after the end of the 2007 to 2009 recession, it slowly decreased its balance by only $600 billion per month and decreased its balance by just $600 billion before financial markets signaled that the system did not have enough cash reserves at hand.

Bostic said he felt there was no need to phase in a balance sheet runoff because markets know what to expect, so the process promises to be much different this time.

Bostic said that they would hope we would move pretty quickly and get out of this emergency stance. The motivation is well-known and the tool is well understood. Bostic said it should go faster and at a quick enough pace to complete the process in a couple of years. The debate on how to treat the Fed's asset holdings got underway at the Fed's December meeting with staff presentations on the issue and initial discussion among policymakers.

Since the outbreak of the pandemic in early 2020, the Fed has bought more than $4 trillion of Treasury bonds and mortgage-backed securities, more than double the overall size of its balance sheet from $4.1 trillion to $8.7 trillion.

The holdings are thought to be holding down long-term interest rates that the Fed may want to move higher in order to curb demand and prices for a variety of goods, which was initially thought to be a way to keep financial markets stable.

Bostic, who does not have a vote on monetary policy this year, was one of the first Fed officials to believe that the pace of the recovery would be stronger than anticipated, and was one of the few to expect higher interest rates in 2022, a year ago, when the economy was slowing down.

He worries that some of the things driving inflation may be here to stay.

Bostic said he takes seriously comments from local business leaders that they are planning for more resilient supply chains that will be more expensive to maintain and that they feel they have pricing power in the market and plan to use it.

Bostic said that the question really is how forcefully or fulsome do we have to respond to make sure it stays in a boundary. I think we need to be acting pretty forcefully.