Waller flags 3 risks to rate outlook as employment strengthens

Federal Reserve Governor Christopher Waller said the central bank may need to keep rates elevated as employment reports continue to strengthen and the risk of an artificial intelligence-driven market correction threatens to upend financial conditions.

"We continue to receive better, stronger employment reports," Waller said in remarks Monday. "If an AI bubble emerges and then bursts or corrects, we will see considerable changes in financial conditions."

Waller said reserve balances remain above $3 trillion, a level he described as abundant, and he sees no reason the banking system is approaching a scarce-reserve regime. He expressed openness to shrinking the Fed's securities holdings further if banks require fewer reserves, though he noted a working group is still studying how far the balance sheet can be reduced.

The remarks suggest the Fed's policy path has become more complicated as a resilient labor market pulls in one direction and financial stability risks tied to elevated asset valuations pull in another. With inflation still above the Fed's 2% target, Waller's comments reinforce the view that rate cuts are unlikely in the near term.

Waller's assessment aligns with recent data showing the economy remains resilient. He said earlier this year that if core inflation measures come in hot, he would have to consider supporting a rate increase — a scenario that would mark a sharp reversal from the easing cycle markets had anticipated.

The governor's focus on AI as a potential source of financial instability adds a new dimension to the Fed's risk assessment. The rapid run-up in technology stocks tied to artificial intelligence has drawn comparisons to past asset bubbles, and Waller's explicit acknowledgment that a correction could have broad economic consequences signals the central bank is monitoring the sector more closely. Samsung Electronics reported preliminary second-quarter operating profit that was almost 20 times higher than a year earlier, underscoring the scale of AI-related demand that has driven equity valuations higher.

Balance Sheet Path Remains Uncertain

On the Fed's balance sheet, Waller pushed back against the idea that the current pace of reduction needs to slow. The central bank slowed the pace of redemptions in June 2024 to help ensure a smooth transition, and Waller said that pace continues to be appropriate. He said he sees no evidence from money market indicators that reserves are becoming scarce, though he acknowledged the Fed should have a contingency plan ready for any disruptions.

"If unanticipated disturbances to reserve demand emerge, the Federal Reserve System has a variety of tools to address such a development," Waller said in a March 2025 speech, a position he reiterated in his latest remarks.

The next FOMC meeting is scheduled for late July. Markets are pricing a low probability of a rate move, with traders focused on whether the committee's statement will reflect the same shift in tone Waller outlined. If inflation data continues to run hot, Waller has previously said he would consider supporting a rate increase.

This article is for informational purposes only and does not constitute investment advice.