Fed’s Brainerd backs gradual rate hikes but warns of ‘imbalances’ that could trigger faster action

The Federal Reserve likely will continue gradual interest rate increases but will accelerate the pace if signs that financial imbalances continue to build, central bank Governor Lael Brainard said in a speech Wednesday.

Speaking in Detroit, the Fed official echoed recent remarks from Chairman Jerome Powell that while the current gradualist approach is appropriate, officials are on the lookout for an acceleration in inflation or distortions in financial markets that would trigger more aggressive action.

“While the information available to us today suggests that a gradual path is appropriate, we would not hesitate to act decisively if circumstances were to change,” Brainard said, according to prepared remarks. “If, for example, underlying inflation were to move abruptly and unexpectedly higher, it might be appropriate to depart from the gradual path.”

The remarks echoed Powell’s speech at the Fed’s annual retreat in Jackson Hole, Wyoming, where he said the policymaking Federal Open Market Committee would take a “whatever it takes” approach to policy “should inflation expectations drift materially up or down or should crisis again threaten.”

Brainard said the progress of the economy, with GDP moving above trend, unemployment low and inflation stable and around the Fed’s 2 percent goal, represent positives. However, she said that various parts of the financial markets are showing excesses.

She again echoed Powell’s comments in saying that overheating sometimes shows up in markets before more conventional inflation measures.

“The past few times unemployment fell to levels as low as those projected over the next year, signs of overheating showed up in financial-sector imbalances rather than in accelerating inflation,” she said. “The Federal Reserve’s assessment suggests that financial vulnerabilities are building, which might be expected after a long period of economic expansion and very low interest rates.”

In particular, she said corporate debt is rising and is susceptible to downgrades if conditions should change. She also noted that leveraged lending is rising as underwriting standards ease and said stock market valuations are “elevated.”

Brainard spoke ahead of the FOMC’s Sept. 25-26 meeting, during which the committee is widely expected to raise its benchmark funds rate a quarter point. Markets expect another hike in December.

However, economists worry that the Fed might invert the yield curve by pushing short-term yields above longer-dated government debt. That inversion has been a reliable sign that a recession is on the way in the next year or two.

Brainard, though, as much acknowledged that the Fed’s short-term “neutral” funds target — the level that supports trend growth with full employment and 2 percent inflation — could exceed the longer-term target. An inverted yield curve is only one of the signs that Fed will heed when making policy, she said.