Federal Reserve Chairman Kevin Warsh’s tough words on inflation on Wednesday resonated in financial markets, with traders predicting the central bank could start raising interest rates in just a few months.
Warsh, who was appointed by President Donald Trump, who has repeatedly called for interest rate cuts, focused his press conference instead on combating inflation, which has exceeded the Fed’s official target of 2% for five years.
“Staying high prices are a burden on Americans, but recent history doesn’t have to be the beginning.” “I am pleased to report that the membership[of the Federal Open Market Committee]is clear and unanimous that this committee will deliver price stability.”
Markets quickly took notice that the new central bank leadership was establishing its credentials to fight inflation.
of 2 year government bond yieldThe stock price soared during Mr. Warsh’s remarks, as the market appears to be reflecting the Fed’s moves.
At the same time, futures market traders began betting on when the next rate hike would occur. At the July 28-29 meeting, the probability of a rate hike rapidly rose to about one-third. The probability of a September rate hike jumped to 67% around midday Thursday, according to CME Group’s FedWatch Gauge.
2 year yield
Dispelling the Warsh story
Additionally, traders are pricing in a significant tightening of Fed policy going forward.
The probability of a second interest rate hike by September 2027 is now over 45%. Looking further ahead, the market suggests a May 2031 federal funds rate of 4.78%, implying as many as five rate hikes over the years from the current target range of 3.50% to 3.75%.
The popular theory that Mr. Warsh was sent to the Fed to loosen monetary policy at all costs was quickly dispelled during a 40-minute meeting with reporters. The sometimes serious, sometimes light-hearted session was notable for its focus on inflation, with Warsh mentioning “price stability” more than a dozen times.
Market veteran Ed Yardeni said he was “shocked” by Warsh’s comments.
“We considered him a dovish supporter of lowering the federal funds rate (FFR) because he believes it boosts productivity and economic growth while controlling inflation,” the head of Yardeni Research said in an evening note. “Instead, he delivered a tough, orthodox message on inflation, with a strong commitment to price stability.”
The shift to anti-inflation shock investors, sending U.S. Treasury yields soaring and stock market averages plummeting.
But concerns about the Warsh Fed potentially becoming more hawkish dissipated on Thursday as Wall Street digested the results of the FOMC meeting and focused more on positive developments in the Iran war and prospects for lower energy costs going forward. Stock prices rose and yields ranged from flat to lower.
Some positives regarding inflation
While the outlook for inflation may already be positive, the chairman’s position seems optimistic that it could be seen as a significant coup. Fundamental pressures have eased, with core inflation rising just 0.2% in May, even though general inflation measures are at multi-year highs and well above the Fed’s 2% target.
Scott Clemons, chief investment strategist at Brown Brothers Harriman, believes the Fed won’t actually make any moves on interest rates this year as it monitors changing inflation dynamics and other factors as they unfold.
“Not that I disagree with the futures market, but I would be surprised if the Fed raised rates this year,” Clemons said. “This is an election year. It’s already a highly politicized environment. There are already concerns about politicization at the Fed. I don’t know if they want to foster that.”
Warsh has said in the past that it’s generally wise to look for temporary supply disruptions that affect prices.
In fact, commodity costs have risen just 6% since the war began in late February, and are down about 17% from their peak in May, according to the S&P GSCI index. If inflation eases, commodity prices continue to fall (gasoline prices were below $4 a gallon on Thursday, according to AAA) and the economy becomes unstable, the central bank could return to an accommodative stance.
“For markets so far, Mr. Warsh’s message has been both reassuring and worrying,” Steve Blitz, chief U.S. economist at TS Lombard, said in a note. “Declaring that inflation will not be dealt with in uncertain terms was reassuring. Stating that the market would decide whether to set interest rates, rather than letting the Fed set them with an eye to where they want them to be, was disturbing (for today’s traders), but ultimately this should provide reassurance.”
