Markets are set for a much more hawkish Warsh Fed than expected
Federal Reserve Chairman Kevin Warsh’s harsh speech on inflation on Wednesday resonated in financial markets; Traders expected the central bank could start raising interest rates in just a few months.
Appointed by President Donald Trump, who has repeatedly called for lower interest rates, Warsh, at a news conference, instead focused on combating inflation, which has run above the Fed’s official 2% target for five years.
“Persistently high prices are a burden on the American people, but recent history need not be a prologue,” he said. “I am pleased to inform members that: [Federal Open Market Committee] It is final and accepted unanimously. This committee will ensure price stability.”
Markets quickly realized that the new central bank leader was trying to prove his competence in fighting inflation.
2-year Treasury yieldThe interest rate, which is seen as a market reflection of the Fed’s moves, rose with Warsh’s speech.
At the same time, futures market traders began placing bets on when the next rate hike would occur. The odds of an increase quickly rose to nearly 1 in 3 at the July 28-29 meeting. According to CME Group’s report, the probability of a rate hike in September rose to 67% at noon on Thursday. FedWatch.
2 year return
Dismantling the Warsh narrative
Moreover, traders have priced in the Fed to pursue substantially tighter policy in the future.
The probability of a second increase by September 2027 has risen to over 45 percent. Further out, the market-implied federal funds rate for May 2031 stands at 4.78%; This represents an increase of about five in as many years from the current target range of 3.50%-3.75%.
The popular narrative that Warsh was sent to the Fed to ease monetary policy at all costs was quickly debunked in the space of 40 minutes of discussion with reporters. The session, sometimes serious and sometimes light-hearted, was notable for its focus on inflation, with Warsh mentioning “price stability” a dozen times.
Market veteran Ed Yardeni said he was “blown away” by Warsh’s words.
“We thought he was a dove who favored lowering the federal funds rate (FFR) because he believes AI boosts productivity and economic growth while keeping inflation in check,” the head of Yardeni Research said in an overnight note. he said. “Instead, he delivered a tough, orthodox message on inflation, combined with a strong commitment to price stability.”
The shift towards fighting inflation shook investors; Stock market averages fell along with the sudden rise in Treasury yields.
But concerns that the Warsh Fed could possibly be hawkish dissipated Thursday as Wall Street digested the FOMC meeting results and focused more on positive developments in the Iran war and the possibility of lower energy costs going forward. Stocks rebounded and yields trended flat to downward.
Some positives about inflation
There seems to be reason for optimism that, in retrospect, the president’s action could be viewed as a major saber rattling in an environment where positive expectations for inflation already existed. Even though popular inflation indicators are at multi-year highs and well above the Fed’s 2% target, fundamental pressures are easing; Core inflation increased by only 0.2% in May.
Scott Clemons, chief investment strategist at Brown Brothers Harriman, thinks the Fed will make no move on interest rates this year as it monitors changing inflation dynamics and the impact of other factors.
“It’s not right for me not to participate in the futures market, but I would be surprised if the Fed raises interest rates this year,” Clemons said. “This is an election year. This is already a hyper-politicized environment. There are already concerns about politicization at the Fed. I’m not sure they want to feed that.”
In the past, Warsh has said it is generally prudent to review temporary supply disruptions that affect prices.
In fact, commodity costs have risen just 6 percent since the war began in late February and are down around 17 percent from their peak in May, according to the S&P GSCI index. If inflation eases and commodity prices continue to decline (the price of gasoline falls below $4 per gallon on Thursday, according to AAA) and the economy wobbles, that could cause the central bank to shift back into an easing position.
“For now, Warsh’s message for markets has been comforting and troubling,” Steve Blitz, chief U.S. economist at TS Lombard, said in a note. “It was comforting to announce that inflation would be dealt with indefinitely. It was uncomfortable to say that markets would decide where to set interest rates, rather than where the Fed wants them to be (for today’s investors, but that should ultimately be comforting).”
