Global markets are facing a "mismatch" with the future of U.S. monetary policy and have the potential for major volatility, St. Louis Federal Reserve President James Bullard said Monday.
In May 2013, the Fed's policy minutes sparked fears that the central bank could start tapering its $85 billion-a-month bond purchasing program.
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The subsequent market reaction became known as the "taper tantrum," with emerging market currencies tumbling as investors started to bring their dollars back to the U.S. in anticipation of higher interest rates. Yields on 10-year benchmark U.S. Treasurys rose above 2 percent and stock markets reeled as volatility spiked.
In an interview on CNBC, Bullard said this could happen again, with the central bank now looking to raise its main benchmark interest rate this year.
"We do have some potential for that today because the Fed funds futures path, the market based one, is a lot lower and shallower than the Fed's actual (summary of economic projections)," he said.
"So there is a mismatch there, that is going to have to be reconciled at some point."
He added that the Fed's statement last week, which took an unexpectedly dovish tone, could have further misplaced market expectations about the first rate hike.
Dollar strength
Bullard also said the strength in the U.S. dollar in recent months has mainly been due to the aggressive policies of the European Central Bank rather than the Fed's potential move on rates.
The euro fell in anticipation of the ECB's bond-buying program, and has move broadly lower since its launch earlier this month. The single currency was trading at 1.0895 against the greenback Monday—still close to parity—despite a sharp reversal in the middle of last week.
Bullard put this move down to the extra liquidity from the central bank, which is set to add $1 trillion to the euro zone economy.
"(The dollar strength) really is the ECB," he said. "They've resisted this for years."
Bullard called it a "major development in global financial markets" and said it was unclear where the dollar-euro exchange rate would go.
The ECB's massive bond-buying program will see 60 billion euros a month ($66.3 billion) pumped into the struggling euro zone economy in an effort to shift the inflation rate to targeted levels and help boost growth in the region.
Officially called the Public Sector Purchase Program (PSPP), the central bank has been buying up public and private sector securities and stated last week that there is "no duration target for the program."
The extra cash that has flooded the economy has caused the euro to fall to a 12-year low against the dollar, which is set to buoy the region's exporters further.
The Fed's unexpectedly dovish message to markets on Wednesday hit the strength of the dollar, however. Fed Chair Janet Yellen indicated that a rate rise could be closer with the removal of the word "patient" from the Fed's statement, but the central bank also signaled that it was not in a hurry to do so.
Bullard admitted that large multinational U.S. firms were being affected by currency movements and their revenues would be hit by the dollar strength. However, he said that a "hedging strategy is part of running a big multinational."
"I am shocked that the dollar would move in a flexible exchange rate world," he quipped.
Bullard, who's generally hawkish but is a nonvoting member of the policymaking Federal Open Market Committee, said there is still "great optionality" for the committee.
"We don't have to make the move," he said on a potential rate hike, adding that the central bank did have "other tools" and would use them "if necessary."
Market participants have continued to amend their bets as to when they think the U.S. could start to normalize rates from near-zero percent. On Monday, Danske Bank analysts released a note saying they expected the first rate hike to come in September.
"Looking at past hiking cycles, rates across the curve tend to move significantly higher three-four months ahead of the first hike," the analysts said.
Goldman Sachs' Chief Global Equity Strategist Peter Oppenheimer told CNBC on Monday that a U.S. rate hike wouldn't happen until September or even later.
