By Michael S. Derby
May 29 (Reuters) - Federal Reserve officials continued on Friday to signal the U.S. central bank may need to raise interest rates in the future if the war in the Middle East leads to a persistent increase in already-high inflation.
The potential shift in the monetary policy outlook has even been embraced by Fed Vice Chair for Supervision Michelle Bowman, one of the central bank's most dovish policymakers. Bowman told a conference in Iceland on Friday that the war and its resulting
energy shock could change her view on the outlook for rates.
"It still seems early to assess the size and persistence of the economic effects from the Iran conflict," she said, adding, however, that "should disruptions persist well into the second half of the year, we could start to see broader effects on inflation."
If that happened, Bowman noted that it was more likely that she would "consider shifting my approach to thinking about the balance of risks."
She stopped short of saying such an environment would require rate hikes.
A number of Bowman's colleagues are worried it may be hard to shrug off the current energy shock as a temporary factor, especially because inflation has remained above the Fed's 2% target for many years. That view has led to a willingness by these officials to consider lifting rates to bring price pressures back in line.
Financial markets believe the Fed's next move will be to eventually raise its benchmark interest rate from the current 3.50%-3.75% range. Before the start of the U.S.-backed war with Iran, which has led to massive supply chain distortions and an energy price surge, Fed officials had been eyeing a rate cut.
Speaking to a business group in New Jersey, Philadelphia Fed President Anna Paulson said on Friday that monetary policy is "well positioned" considering the unacceptably high inflation pressures and economic uncertainty.
Paulson added that the Fed is ready "to react," and while she sees U.S. monetary policy in the right place, "I think it is healthy that market participants have taken on board scenarios where the (federal) funds rate remains unchanged for an extended period, as well as scenarios where further tightening becomes necessary."
WORRYING INFLATION DATA
Inflation risks are clearly mounting for the Fed, at least in the near term.
A New York Fed gauge designed to capture underlying inflation dynamics jumped to 4% in April from 3.5% in March, according to data released on Friday. Prices of goods and services excluding housing accelerated in April relative to the prior month.
Additionally, data released by the U.S. government on Thursday showed the Personal Consumption Expenditures Price Index rose to 3.8% on a year-over-year basis in April from 3.5% in March.
Kansas City Fed President Jeffrey Schmid, speaking at the same conference as Bowman, said his "primary concern is inflation, which is too hot and has been above target for too long." He added that the textbook strategy of looking through an energy shock as something that won't have a lasting impact is not viable right now.
Schmid also nodded toward the prospect of using the Fed's balance sheet to help pump the brakes on price pressures.
"We're not very restrictive at this stage and I think there's some dialogue that ... we need to start considering what tools we have to really make it a little bit more restrictive" depending on how the oil shock plays out.
"Maybe we look at the balance sheet again as another tool to ... create some restriction," Schmid said, indicating some sort of new drawdown in Fed holdings could create the needed headwinds for economic growth.
His view on the balance sheet is likely to be at odds with that of Fed Chairman Kevin Warsh, who has expressed skepticism about using the central bank's bond holdings to augment its interest rate policy.
Money market conditions and the Fed's rate-control toolkit also limit how far those holdings can be shrunk without creating market volatility. The central bank is currently rebuilding liquidity after conditions tightened late last year.
(Reporting by Michael S. Derby; Editing by Paul Simao)
