Hot Inflation Report Puts Pressure on Federal Reserve

“We don’t have to make that decision today,” Cleveland Fed President

Loretta Mester

said in an interview on Bloomberg Television.

Fed officials are set to begin their premeeting quiet period on Saturday, leaving little time to shape expectations around their policy plans.

Economists said Wednesday’s inflation report suggested the Fed will face pressure to continue big rate rises for a longer period, boosting the risks of a recession over the next year.

The Labor Department’s consumer-price index rose 9.1% in June from a year before, the fastest pace in more than 40 years, and revealed a broadening in price pressures even after accounting for a large increase in food and energy items last month.

“There was nowhere to hide in this report,” said Tim Duy, chief U.S. economist at SGH Macro Advisors. It “was a straight-up disaster for the Fed.”

Fed Chairman

Jerome Powell

last month said the central bank was likely to consider a rate increase of either a half percentage point or 0.75 point at its July 26-27 meeting after it raised rates in June by 0.75 point. On Wednesday, Ms. Mester suggested recent economic data would lead officials to choose between raising rates by 0.75 point or a full point.

Investors in interest-rate futures markets and some analysts judged that the central bank would approve a one-percentage-point rate increase at its meeting in two weeks. The probability of a one-point increase rose to around 79% on Wednesday, up from around 12% before the report, according to CME Group.

“We’re having this conversation. The markets are having a conversation, and putting their money where their mouth is,” Ms. Mester said. “We at the Fed have to be very deliberate and intentional about continuing on this path of raising our interest rate.”

When asked about the prospect of a one-point increase at a news conference last month, Mr. Powell said, “We’re going to react to the incoming data and appropriately, I think. So I wouldn’t want to put a number on what that might be.”

Before Wednesday’s CPI report, many Fed officials had said they expected a 0.75-point increase would be appropriate later this month.

Earlier Wednesday, the Bank of Canada raised its policy rate by a full percentage point, which was more than economists and investors had anticipated.

U.S. interest-rate expectations are volatile partly because the Fed made a surprising shift in June. Most officials at the central bank had provided specific guidance that the Fed would raise rates by a half percentage point at the June meeting ahead of their premeeting quiet period. But the CPI report released days before the meeting prompted the Fed to make the larger 0.75-point rate increase.

Economists at Nomura Securities said it was a close call, but that they now anticipated a one-percentage-point increase in July. “The Fed’s inflation problem has worsened, and we expect policymakers to react by scaling up the pace of rate hikes to reinforce their credibility,” they wrote.

Others said that the Fed, having already torn up its rate guidance in June, would be less likely to do so again. When Mr. Powell and his colleagues signaled either a half-point or 0.75-point in July, “one would think those outcomes reflect the potential data surprises,” said Karim Basta, chief economist at III Capital Management in Boca Raton, Fla. He said he thought the inflation data cemented a 0.75-point move this month.

Roberto Perli,

head of global policy research at Piper Sandler, warned clients that the larger of the two rate increases couldn’t be ruled out because the central bank has signaled that it wants to raise rates to levels high enough to slow the economy. Some officials have indicated that such a rate could be around 3% or higher right now.

Either way, the inflation report would make it much more difficult for the Fed to shift down to more traditional quarter-point rate rises later this year, said Mr. Perli.

“I don’t want to front-run the policy process, but it certainly makes the case even stronger to continue to be resolute to fight inflation,” Richmond Fed President Tom Barkin said in an interview Wednesday.

Mr. Barkin said he was more concerned about moving interest rates above the level of inflation that investors are expecting over the next two years to achieve a positive “real” interest rate.

Any individual quarter-percentage point move at a Fed meeting “is not nearly as important to me as the destination, which is, where do you want to take forward-looking real rates?” Mr. Barkin said. “To have the kind of impact on inflation you want to have,” shorter-term interest rates “need to get into positive territory.”

The types of inflation data reported Wednesday “will make that even more challenging and make our job even harder,” he added.

Rising fuel costs and supply-chain disruptions from Russia’s war against Ukraine have sent prices higher in recent months, but Wednesday’s report was alarming because it revealed broader price pressures that had been gaining momentum before the conflict. Demand surged last year from the reopening of the economy and aggressive government stimulus.

The core CPI, which excludes volatile food and energy categories, rose 0.7% from May and 5.9% from one year earlier.

Still, Mr. Barkin said he was hearing more signs from businesses and consumer groups that the economy was softening, particularly for lower-income workers, which was one reason why he continued to forecast that inflation pressures would soon moderate.

The Fed’s concern about consumers’ expectations of future inflation helps explain why it is paying closer attention to an inflation measure that includes volatile food and energy prices. Normally, the Fed prefers to look through fluctuations in food and energy categories and focus instead on core inflation, which has more reliably forecast future inflation.

Officials are putting less weight now on core readings because of concerns that inflation has become harder to forecast more generally. Also, they are especially worried that inflation psychology could be shifting in a way that will lead consumers and businesses to continue to accept higher prices. Central bankers and economists, having studied the experience of the 1970s, worry that those expectations can be self-fulfilling, leading overall, or “headline,” inflation to stay high.

“Headline inflation is what people experience,” Mr. Powell said at a news conference last month. “They don’t know what core is. Why would they? They have no reason to. So expectations are very much at risk due to high headline inflation.”

Monetary-policy textbooks say central banks shouldn’t react to supply shocks if they expect the increase or decrease in the price of a good, such as oil, to fade over time. Doing so could aggravate the economic damage from the price shock.

Still, Fed officials have said recently they can’t raise rates more gradually because of concerns that a combination of shocks might lead to a higher-inflation environment. “There’s a clock running here,” Mr. Powell said at a central-banking forum in Portugal last month. “Our job is literally to prevent that from happening.”

The current economic environment, where businesses are being buffeted by difficulties finding workers, supply-chain woes, and higher commodities prices, has made it harder for the Fed to ignore the types of shocks that it might have overlooked in the past. “The thing that I think is at risk is our ability to see through shocks,” Mr. Barkin said.

Write to Nick Timiraos at nick.timiraos@wsj.com