Inflation Heightens Fed Debate Over Pace of Rate Rises

The debate still has weeks to play out but could lead officials to begin lifting interest rates from near zero next month, with a larger half-percentage-point increase rather than the standard quarter-percentage-point move. The Fed hasn’t raised rates by a half percentage point since 2000.

On Thursday, the yield on the two-year Treasury note, which is especially sensitive to near-term monetary policy, settled at 1.560%, according to Tradeweb, compared with 1.346% on Wednesday, representing the largest such increase since 2009. The 10-year yield climbed above 2% for the first time since mid-2019, closing at 2.028%. The S&P 500, Dow Jones Industrial Average and Nasdaq Composite all fell at least 1.4%.

Expectations of a larger March rate increase ratcheted higher twice on Thursday—first when the Labor Department reported that consumer prices rose in January by a somewhat larger margin than economists had anticipated, and later when a regional Fed president said the stronger inflation data would justify the greater rate increase.

Thursday’s report showed consumer prices in January rose 7.5% from a year earlier, and so-called core inflation, which excludes more volatile food and energy items, rose 6%. Both were their highest levels in 40 years.

Fed officials in the months ahead are watching for signs that the month-over-month pace of price increases will slow, and Thursday’s report brought little comfort on this front. Elevated inflation has been primarily driven by brisk demand for goods, shipping bottlenecks and shortages for intermediate goods such as semiconductors, but prices in January firmed up in the service sector.

Analysts said the figures indicated the Fed would need to move rapidly this year to pull back extraordinary stimulus provided during the pandemic to prevent inflation from rising higher still.

“The Fed is deeply behind the curve on inflation. There is no other story at this point,” said Tim Duy, chief U.S. economist at research firm SGH Macro Advisors.

Officials will have one more monthly inflation report to read before their next meeting, March 15-16.

While some analysts and one Fed official floated the prospect Thursday of raising interest rates before their scheduled meeting, the central bank is unlikely to take such a step. It last did so in April 1994, a period when the Fed was only beginning to provide more guidance to markets about its policy intentions.

By contrast, since Fed Chairman Jerome Powell signaled plans to raise interest rates over the last few months, bond investors have adjusted their expectations. Yields now reflect that the Fed will raise interest rates more aggressively, including at their scheduled policy meetings in March, May and June.

Until Thursday, Fed officials had largely pushed back against market speculation that they might take the more aggressive step of a half-point rate rise in March. They generally had signaled they were comfortable with how markets had interpreted the possibility that the Fed might raise rates at their next three meetings.

St. Louis Fed President James Bullard said in an interview Monday that he didn’t think the larger rate increase was warranted.

“We don’t want to be disruptive or surprising markets…I would like to do this in the smoothest way possible, and we, so far, have achieved that,” he said, adding that he would change his view “if the data went against us here.”

But Mr. Bullard suggested Thursday that he was open to a half-point increase in March or to raising interest rates in between the scheduled policy meetings.

“We are going to have to be far more nimble and far more reactive to data,” he told Bloomberg News. “There was a time when the committee would have reacted to something like this to having a meeting right now and [raising rates] right now.”

It is the latest sign of how monetary policy is entering a more fluid and unpredictable new phase, and Thursday’s report could lead other Fed officials to call for a larger rate increase in March. On Wednesday, Cleveland Fed President Loretta Mester said in a virtual speech that she didn’t at that point see “any compelling case to start” with the larger half-percentage-point increase.

Exactly how the Fed sequences its next moves rests with Mr. Powell, who is awaiting Senate confirmation to a second four-year term leading the central bank. “If the Fed is going to move early and fast, it’s going to be…Powell that makes it happen,” said Mr. Duy.

While Fed officials pushed back in recent days against a larger rate rise in March, the calculus could shift as markets come to expect such an increase, as they did on Thursday.

Interest-rate futures markets showed investors judged a nearly 50% probability of a larger rate increase, up from around 25% Wednesday, according to CME Group, after Thursday morning’s inflation report. Those probabilities rose to 90% by the end of the day, after Mr. Bullard’s comments.

Officials must balance whether larger, upfront rate increases would give them greater flexibility to slow rate increases later this year if inflation declines, against the potential risks of fueling market expectations for even bigger and potentially more disruptive moves.

“If you do a [half-point increase], it makes sense in the abstract, but how do you communicate and shape expectations after that?” said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives.

A faster series of rate rises heightens the prospect of more intense financial-market volatility. But it could also help return rates closer to a neutral setting, which most officials judge is between 2% and 3% when inflation is at the Fed’s 2% target. Such an adjustment would be designed to neither spur nor slow economic activity. That would allow the Fed to then raise rates above neutral to deliberately weaken the economy and lower inflation.

Fed officials are also grappling with how fast and soon to shrink their $9 trillion bond portfolio. The Fed said last month it that would approve a final round of $30 billion in bond purchases in February before ending the portfolio expansion next month.

Mr. Powell said last month that he expected supply-chain bottlenecks to keep inflation elevated through the first few months of this year. At a press conference last month, he said he believed the inflation situation had deteriorated slightly since officials’ economic projections from mid-December.

“It hasn’t gotten better. It’s probably gotten just a bit worse, and that’s been the pattern,” Mr. Powell said on Jan. 26.

—Sam Goldfarb contributed to this article.

Write to Nick Timiraos at nick.timiraos@wsj.com