Joining us now to extend the conversation on the Federal Reserve, the San Francisco Fed President, Mary Daly, joined us for more. President Daly, always good to hear from you. So, thanks for making some time for Bloomberg Surveillance here.
I want to bring up the bond market, and I'm sure you anticipated I would go there first. The long bond and the rise we're seeing in yields, President Daly, from your standpoint, what signal, if any, do you take from the sell-off at the long end?
Well, you know, when you look at the long end, it is typically driven by structural factors like fiscal sustainability, geopolitical rebalancing, the massive AI investment for this industrial renaissance which people are very excited about, and those factors are driving this. The thing that I look at specifically is this is happening across the globe. It's not just a US phenomenon. It's a global phenomenon and it doesn't give us a lot of signal about what we should do in the policy adjustments or the policy calibration for the Fed. And there we look at the short end more than the longer end, paying attention to the longer end but really focusing on job number one, which is restoring price stability right now.
Do you think, President Daly, that the long end of the yield curve is doing some of the work for the Federal Reserve by tightening monetary conditions in a more significant way?
You know, I always hesitate to say that the market's doing our work. But what I will say is it begs the question, what problem are we trying to solve by adjusting policy preemptively? You know, there's a lot of discussion about our credibility there. I don't see our credibility at risk. I also hear a lot about should we be making preemptive cuts or hikes rather, and I don't see a lot of evidence that that's an urgent problem to solve. So really this is about watching the inputs from the financial markets, looking at the 30, the 10, and the 2, and asking are we getting mixed signals or different signals. And you know, right now on the shorter end of the yield curve, markets seem to have priced in a little bit more tightening, but they're reacting to the data just like we would expect them to. Inflation prints a little softer than they expect, the labor market a little softer than they expect, they push out rate hikes that they had priced in and adjust as the data comes. So I think they seem to be signaling to us that they understand our reaction function. And importantly, I'm looking at inflation compensation and inflation expectations, and you don't see any worrisome swings in those pieces of data either. So I think policy's in a good place, but watching this 10 and 30 to see what we need to think about, what are the structural factors, it's giving us a signal about something, and I think one of the big signals is the AI demand.
President Daly, we'll get into AI demand, but I am curious about the reaction function. You said that the market seems to be understanding the Fed's reaction function. What is your reaction function in terms of incoming information that would make you think that an adjustment higher for rates would be required?
Well, you know, last week I gave a speech where I talked about really there's many scenarios that could occur, but two seem very important for me at this point. One is the one that I would suggest is the modal outlook. My modal outlook is that, and also you saw in the minutes, it's a majority of the participants' modal outlook, that inflation is being driven up by a series of shocks and those shocks will roll up, they'll roll down, they'll roll through, and as that dissipates then inflation will return to target in part because we have policy at a very slightly restrictive level. So there's that dynamic, but then there's the dynamic of maybe the fact that we have so many shocks coming at once and they're overlapping, they can have an independent compounding effect that means that the total effect is greater than the sum of its parts. The conventional dynamics of shocks just aren't working like they were. I'm not seeing evidence of that right now, but I definitely think we should keep that in mind and watching. If that happens, we'd have an inflation problem that we would want to treat with tighter policy. In the meantime, I was very supportive of the July hold and continue to look at the information that comes between now and the next meeting about whether any signs of that worrisome dynamic would be forming, and I haven't seen them yet. And the recent prints on both inflation and the labor market didn't really change that picture for me at this point.
There's been kind of a paradox forming right now where you've seen inflation above target for more than five years at the same time that the labor market seems to be kind of meh. I mean it's okay but people keep talking about low hiring, low firing, and that kind of dynamic with real wages not keeping pace for the past five years will lead inflation to go lower. Why hasn't it? Right? I mean when does that relationship reassert itself?
Well, one of the things that is true is that we've had many periods in our history with, you know, essentially if you're thinking in economics terms, where the Phillips curve is very flat and you just don't see the relationship between the labor market and price inflation. And it also kind of illustrates why the shocks have been a big component of overall inflation. You know, the tariff shock, the oil price shock, and now the AI investment boom shock. And in all of those, you have to ask what is the expectation of their duration? Are they spreading to other sectors than the ones that they directly affect? And what do we think they will do if they compound with each other? Will that make a difference or will it not? So, I think that's what's really driving it. I wouldn't look to the labor market. You don't see any signs that the labor market is contributing to inflation. And I really think at this point you have to look at these other factors because that link between wages and price stability is often weak. We came off a period where it was very strong because we saw a very frothy labor market, very strong labor market, and people were saying that they were worried about a wage-price spiral. I think I've talked to you both about that. But we're way past that and now we have to look at these other factors driving inflation. And so I'd say the main contributor to why inflation has persisted for so long even when we've had restrictive policy is because we have these shocks and then of course service price inflation is just stickier. It takes a while to come down.
President Daly, I'm just going to keep our audience on top of the moves we're seeing in the bond market at the long end of the curve. Up by close to seven basis points, 30s at the moment. If you bring up the board, around 526, yields higher through the levels. This is important. We've taken back much of the rally. In fact, all of it since we had that Treasury announcement this time yesterday at 8:30 Eastern time. Off the back of this move in the bond market, equity futures lower by 0.6% on the S&P 500. President Daly, I can imagine you'd love to avoid all the conversation about Treasury, the department, and issuance, but forgive me, I have to go there. There are many people who believe we'll see a continuation of this Treasury Department under Scott Bessent, of the policies that we saw under Janet Yellen, and that we'll see less issuance at the long end and more supply at the front end. If T-bill issuance continues to climb and account for more and more of the issuance coming from the Treasury, President Daly, how does that change your view on what to do and what not to do with policy? What does it mean for the everyday workings of the Federal Reserve who is very focused on managing short-term rates?
Well, I'd say these are early days and I wouldn't want to be preemptive in sort of discussing those types of things until we've had a chance to think through those issues. But, you know, the Treasury Secretary is different than the Fed. The Fed is talking about price stability and full employment. And what I do know is, and we've historically been able to do this, is that we have a goal and we can achieve those goals through our policy implementation and we will find a way to do the job that Congress gave us, which is restore inflation to 2% as our goal as we define it, and do that price stability. So I think we don't want to worry about the mechanics of how to do that as much as the commitment to achieve it.
