The Fed will be prepared to hold interest rates "higher for longer" should inflation continue to surprise to the upside, and market pricing will need to adjust accordingly, Federal Reserve Bank of St. Louis President James Bullard told MNI Tuesday.

"I was a bit hoping that we could get (rates) to 3.75% to 4% this year and then sort of see what was happening during the winter, in the first quarter of next year, and make a judgment at that point about whether more rate increases were needed," he told the MNI FedSpeak podcast. "If we do get inflation slowing down, then we may be able to hold the rate at that higher rate for that period of time."

But with inflation topping forecasts time and time again, "It's certainly possible we could continue to get surprised to the upside here. And if that's the case, we'll have to be higher for longer, and the market has to price that in."

U.S. CPI soared 9.1% in June, several tenths above market expectations and marking a fresh four-decade high. July data, due Wednesday, is expected to ebb after energy prices have retreated. (See MNI: CPI Shortens Odds Of 75BP Hike In Sept.-Ex-Fed Staffers)

“It’s too early to make the claim" that inflation has peaked, he said, adding it's "disconcerting to not see equal amounts of betting on either side." Investors overwhelmingly believe that inflation will come down in short order, but "if you look at the track record over the last year, that has been a bad bet."

FRONTLOADING

Whether the Fed lifts rates by another unusually steep 75 basis points or in September is "a tactical decision" to be made with more CPI and jobs reports in hand, Bullard said.

"I have liked frontloading rate hikes, and I continue to think that we'll have to get to 3.75% to 4% by the end of this year. Whether we want to do more in the September meeting and less in later meetings or spread it out evenly is a tactical decision," he said.

“I think the destination is a little bit higher than what I would have thought even a couple months ago because inflation has continued to broaden out and doesn't look like it's turning the corner at least based on the evidence we have today.”

A good indicator of underlying inflation, the Dallas Fed Trimmed Mean gauge, has risen "straight up" since the fourth quarter and now sits at 4.3%. "We need to put downward pressure so that a measure like that is turning around in a convincing way and moving lower toward our target or 2%," he said. "I'd like to see that stabilize or come lower by the time we get to the end of this year."

Headline inflation numbers will continue to be important to watch, as well as anecdotal reports from firms, Bullard said. "I'd especially like to see firms worried that if they increase prices, they're going to lose market share, perhaps permanently, or even ruin their business by increasing prices too far."

NO RECESSION

The U.S. is not in a recession now, predictors of future recession chances may not be straightforward, Bullard said.

The economy added 2.7 million jobs in the first half of the year and unemployment has been falling. That employers added 528,000 jobs in July was above anyone's expectations, including his own. "The jobs data is wildly at variance with the idea that we're in recession," he said. "So these are just not recession numbers as far as the labor market is concerned."

The inverted yield curve, which some say could predict a slowdown, may be due to the idea that markets think inflation will be high a year or two from now but fall further out, Bullard said.