San Francisco Fed President Mary Daly said in a speech on Tuesday that the neutral rate may be higher now than it was before the pandemic, but rates will not remain at their current high levels indefinitely.
She also noted that financial conditions have tightened recently and the Fed may not need to do as much more.
Speaking at a City Hall event in Chicago on Tuesday, Daley said, "5 percent is not going to be the new neutral rate. There is no evidence that this will be the new neutral rate - this is still the policy rate that is trying to fight high inflation."
As of now, the Fed has raised the target range for the federal funds rate from 0.25 to 0.5 percent in March 2022 to 5.25 to 5.5 percent in July 2023, the highest level in 22 years.
The Fed left its benchmark interest rate unchanged at its September policy meeting. Right now, the Fed is considering whether it will need to raise rates again in 2023.
The US economy has proved surprisingly resilient in the face of the Fed's aggressive campaign to raise interest rates. The resilience has also led to speculation that the so-called neutral interest rate for the economy may have risen. Since the pre-pandemic period, Fed officials have consistently seen the neutral interest rate for the US economy at 2.5 per cent.
Daly also believes that a new neutral rate between 2.5% and 3% is definitely conceivable.
Economic risks are more balanced
At the same time, Daly noted that with inflation coming down from its peak, the risks of too much and not enough tightening are roughly balanced, and the risks of not raising enough are no longer much higher than the risks of raising too much.
But even so, she warned that non-housing services inflation needed to slow further and that "we have more work to do and inflation remains high".
Daly also suggested that the tightening of financial conditions caused by the recent spike in U.S. Treasury yields could reduce the need for further rate hikes. Since the September meeting, the 10-year Treasury yield has risen about 25 basis points.
"Recently, bond yields have tightened, meaning financial conditions have tightened. Maybe the Fed doesn't need to do that much... This could amount to another rate hike." Higher yields would raise borrowing costs and potentially slow spending and investment.
Futures markets point to less than a 20 percent chance that Fed officials will raise rates by another 25 basis points at their next policy meeting.
After the Israeli-Palestinian conflict erupted over the weekend, investors opted for more safe-haven U.S. Treasurys. Treasury yields have given up some of their recent gains this week.
Regarding the recent war, Daly believes that the current geopolitical uncertainty has exacerbated economic uncertainty and made businesses cautious, and the Fed will closely monitor the impact that the war may have on oil prices or export demand.