Federal Reserve's "third-in-command": Inflation has not changed the baseline for decline, interest rates are at a reasonable level.

John Williams, the President of the New York Fed, released a clear policy signal in an interview on Monday: he remains optimistic that inflationary pressures will gradually ease, but if inflation does not decline as expected, the Fed will not hesitate to raise interest rates. This statement followed the Fed's decision last week to maintain interest rates unchanged by a vote of 9 to 3, with three hawkish members casting dissenting votes, providing the market with the latest authoritative guidance on the monetary policy path. As the third-highest official in the Fed with permanent voting rights, Williams' remarks lend strong backing to the decision to hold steady in July and subtly cool the market's excessive bets on interest rate hikes. Inflation Assessment: Three Major Drivers Are Easing, 2% Target by 2028 Is Achievable Williams broke down the current inflationary pressures into three core sources and provided his assessments for each: First, the impact of tariffs has essentially peaked. Williams believes that the inflation-boosting effects of the tariff policies from the Trump administration have largely been transmitted to prices, and the additional push to the inflation rate in the coming months will significantly weaken. He noted that some of the major factors that have raised inflation over the past 18 months will clearly fade, and previously observed disinflationary forces will re-emerge. Second, the impact of conflicts in the Middle East is expected to diminish. Although the ongoing U.S.-Iran conflict continues to drive energy prices higher, Williams believes that futures markets and experts still expect the conflict to be resolved eventually, with energy prices likely to decline later this year. He stated that at least in his baseline forecast, the Middle East conflict will not continue to push up inflation in the second half of this year or next year. Once the situation is resolved and shipping returns to normal, improvements could happen very quickly. Third, ongoing observation of AI demand is needed. While strong investment demand driven by AI is pushing up prices of some goods, Williams does not consider it to be a primary driver of inflation at this time, categorizing it as a variable that requires continuous observation. Based on this, Williams maintained the same inflation outlook as during the June FOMC meeting: the baseline prediction remains to achieve the 2% inflation target by 2028. He personally predicts that inflation will begin to decline in the second half of this year and will further decrease next year. From a DRIVE perspective, falling housing costs, a retreat in goods inflation, and cooling core services inflation will continue to drive inflation down. Excluding energy and food prices, as the Middle East conflict no longer exerts pressure on prices, core inflation indicators should ease. Policy Stance: Interest Rates Are Well Positioned, But Rate Hike Options Are Completely Appropriate Williams reiterated that the current stance of interest rate policy is in a favorable position, sufficient to drive inflation back to target. He strongly supports last weeks FOMC decision to keep the federal funds rate unchanged in the range of 3.50% to 3.75%. He believes that the U.S. economy is growing close to trend levels, the labor market is stable, and there are no signs of overheating. Nevertheless, Williams also clearly warned that if the trajectory of economic development cannot bring inflation back to 2%, then taking action to put the economy back on the path to achieving the 2% inflation target will absolutely be appropriate. He particularly emphasized that he is very concerned about the performance of core inflation data in the coming months, and whether these data align with the trend of inflation heading toward 2% and genuinely embarking on a sustained downward path. The subtext of this statement is clear and measured: inflation data will determine everything. If core inflation does not show signs of a steady move toward 2% in the coming months, rate hikes will quickly be on the table. Market Dynamics: Not Following Market Pricing, Not Recognizing Forward Guidance Williams' interview also sent two important signals about the Feds decision-making framework. First, the Fed will not be held hostage by the market. When asked whether the Fed would adjust policy due to market expectations, Williams responded unequivocally: Absolutely not. He emphasized that the Fed will closely monitor financial market dynamics but must always conduct its own analysis independently and carry out the necessary research. This statement is an indirect response to the recent significant market betting on a September rate hike, indicating that the Fed will not simply follow market pricing. Second, forward guidance is currently out of context. Williams pointed out that given the high current economic uncertainty, clear forward guidance is no longer appropriate. When asked whether the Fed would adjust policy based on market expectations, Williams provided a clear negative response. He noted that the Fed is adapting to the communication style of new chair Kevin Walshwho has gradually downplayed so-called forward guidance and no longer preemptively signals future policy paths. AI and Financial Stability: Volatility Is Normal, Leverage Is Manageable On the topic of AI, Williams offered a relatively optimistic assessment: AI is not a bubble; he believes it to be a general-purpose technology with transformative potential, and the current investment enthusiasm reflects the market's expectations for productivity improvements and new business models. The recent volatility in the AI sector is not surprising, as it is a normal characteristic of a highly innovative and rapidly changing industry. Moreover, leverage does not pose a threat. Regarding the risks posed by corporate borrowing for AI investments, Williams believes that the current level of corporate leverage is nowhere near the levels seen 20 years ago that triggered the global financial crisis. Most of these companies have very strong profitability, so he is not particularly worried that the current leverage levels will lead to financial stability risks.