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Fed hawks signal downshift in U.S. rate hikes after July

By Lindsay Dunsmuir and Ann Saphir

(Reuters) -Two of the Federal Reserve's most vocal hawks on Thursday said they would support another 75 basis-point interest rate increase later this month but a downshift to a slower pace afterward, even as both downplayed the risk of higher borrowing costs pushing the U.S into recession.

"I am definitely in support a doing another 75 basis-point hike in July," Fed Governor Christopher Waller said during a discussion with the National Association for Business Economics.

"Probably 50 in September," Waller added, "and then after that we can debate whether to go back down to 25s or if inflation just doesn't seem to be going down, we have to do more."

At a separate event in Little Rock, Arkansas, St. Louis Fed President James Bullard also said a 75 basis-point hike at the U.S. central bank's next policy-setting meeting on July 26-27 would "make a lot of sense."

The move would bring the policy rate to a range of 2.25%-2.5%, about a percentage point short of the 3.5% level Bullard said he continues to advocate for by the end of the year. Stretched out over the three meetings left after the one this month, his view also points to a slowdown in the pace of rate hikes, though he did not map that out explicitly.

The Fed last month raised its benchmark overnight interest rate by three-quarters of a percentage point, its biggest hike since 1994, as it stiffens its resolve to tame stubbornly high inflation without causing too much economic harm.

Waller's comments had an immediate impact on market expectations, with investors reducing bets on the Fed hiking rates by 75 basis points in September to 13%, down from 23% before he spoke, according to an analysis of Fed funds futures contracts by CME Group, which shows an 80% probability of a 50 basis-point rise at that meeting.

Rate futures traders continue to expect a 75 basis-point hike this month.

OVERBLOWN FEARS

Rising interest rates, inflation and tighter financial conditions have darkened the economic outlook, with recent data on consumer spending and factory output showing signs of a slowdown and sparking recession fears.

Waller was mostly unmoved, citing services data as well as a strong labor market although he acknowledged there are dangers.

"I personally think some of the fears of a recession are overblown," he said. "We're going to get inflation down. That means we are going to be aggressive on rate hikes and we may have to take the risk of causing some economic damage, but I don't think, given how strong the labor market is right now, that that should be that much," he said.

Raising rates to 3% or slightly higher will not send the unemployment rate, now at 3.6%, to something dramatically higher like 6% or more, he said.

Bullard likewise said that labor markets, currently nearly as healthy as they have ever been, could cool quite a bit and still remain strong, and that his "base case" is for a softish landing where growth slows from its soaring pace last year. "Some people are mistaking that for recession" he said.

While GDP, the most widely cited measure of U.S. output, fell in the first quarter and looks on track to fall again this quarter, output by a different measure more reflective of the labor market has remained positive and is expected to stay so.

Economists expect a fresh read of the U.S. labor market on Friday to show employers added 268,000 jobs in June, fewer than the prior month but enough to suggest continued economic growth rather than a stalling of it, let alone a contraction.

Bullard said he expects inflation to fall rapidly as the Fed puts in its rate hikes, though most of the decline will come next year, not in 2022. Bullard said that once the Fed gets rates to 3.5%, it should assess the state of inflation and inflation expectations, and then could tweak policy to suit, including potentially by cutting rates.

(Reporting by Lindsay Dunsmuir in Scotland and Ann Saphir in Berkeley, Calif.Editing by Paul Simao and Matthew Lewis)