Gundlach says Fed must raise rates above 3.5% to hit inflation target

The bond market is telling the Federal Reserve it has fallen behind on inflation, and rates need to go higher.

The Fed left its benchmark rate at 3.5% to 3.75% on Wednesday, but bond yields are rising as traders bet the central bank will need to hike again to reach its 2% inflation target.

"The bond market is telling Kevin Warsh the Fed has to start acting on inflation," Jeffrey Gundlach, chief executive officer of DoubleLine Capital, said. "The market doesn't believe the Fed is done."

The decision to hold at 3.5% to 3.75% came as inflation remains above the central bank's 2% target. Warsh stressed that the Fed will take necessary steps to meet its inflation goal, without specifying the timing or magnitude of potential action. Gundlach's warning adds pressure on the central bank to justify its pause, with the bond market pricing in a higher probability of rate increases in coming months.

If the Fed is forced to resume hiking, it would mark a reversal from the easing cycle that brought rates down from their 2023 peak. The next policy meeting will be closely watched for any shift in language that signals the central bank is preparing to act.

The last time the Fed held rates while inflation ran above target was in the first half of 2024, when the central bank maintained a restrictive stance for eight months before eventually cutting by 25 basis points in September of that year. That cycle saw the 2-year Treasury yield peak near 5% before declining as the Fed pivoted. The current setup mirrors that period in some respects, though the rate level is lower now at 3.5% to 3.75%.

Gundlach, who oversees more than $100 billion in assets at DoubleLine, has a track record of calling major market turns. His comments carry weight among fixed-income investors who look to the bond market as a leading indicator of economic conditions. The yield curve has been mixed, with short-term rates remaining elevated relative to long-term bonds, a configuration that historically has preceded economic slowdowns.

Warsh, who took over as Fed chair earlier this year, has emphasized data dependence in his policy approach. The July statement maintained the central bank's commitment to bringing inflation down to 2%, but the lack of explicit forward guidance left markets guessing about the next move. Futures markets will now focus on economic data releases in the weeks ahead for clues on whether the Fed's next move is a cut or a hike.

The bond market's message is clear: at current rate levels, financial conditions may not be tight enough to complete the inflation fight. If Gundlach is correct and the Fed must act, the coming months could see a repricing across fixed income, equities, and currency markets as investors adjust to a higher-for-longer reality.

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