We’ll learn a lot on Wednesday about whether new Federal Reserve Chairman Kevin Warsh’s decision to be less clear about the outcome of the meeting is a better way to set monetary policy.
These lessons could be reflected in the amount of market volatility around the decision, during and after the chairman’s press conference. Something has to give, but how much and in what direction is unknown.
What is known is that the federal funds futures market is split an unusual 35% to 65% on the outcome, with a majority believing the Fed will keep interest rates unchanged at 3.63% but is betting heavily on the possibility of raising them. The market typically has a 95% probability of the correct outcome of a meeting in the days leading up to the meeting. If the majority is correct, the minority’s bet must be resolved.
This shouldn’t cause much volatility, said John Canavan, principal analyst at Oxford Economics. Where else the minority bet lies is less clear. Two-year bond yields have remained high despite weak inflation and employment data. Even when crude oil prices fell from mid-May to the end of June, it did not fall. The decision and press conference could lead to even more volatility given the much larger U.S. Treasury market has significant bets on the outcome of this meeting.
What’s more interesting is whether the potential rate hike is holding back the stock market. Stocks are highly sensitive to hot or cold views on hyperscalers’ earnings and ever-changing prospects. But some of the hedge against rate hikes could still be in stocks, and if the consensus is right, stocks could soar.
But it may not be so dualistic. These hedges could be maintained if the Fed leaves rates unchanged with multiple dissenting opinions, or if a new sentence is added to the statement that suggests a hike bias. Ahead of Wednesday’s meeting, Fed futures were trading with an 80% chance of a rate hike in September and a 60% chance of a second rate hike in December. So what may be wrong now could be right in just a few weeks.
The magnitude of the swings surrounding Wednesday’s decision may not matter much. But volatility could raise questions about whether a lack of transparency is a better way to manage policy. “In all my years as an economist, I’ve never seen a single theory that says people are better off and markets work better if you don’t tell people what you think,” said Fed Chairman Chris Waller in a recent speech in New York City.
In general, the goal of policy was to gently guide the market in the direction the Fed thought it should go and help the Fed achieve its goals.
Warsh has other ideas. He said the Fed should set policy more based on market signals and less on Fed guidance. Still, it remains unclear which markets Warsh is focusing on and what signals he’s getting from them. In the Fed futures market, the correct decision is to hold. The implied inflation rate in the TIPS spread also indicates that there is little inflation concern in the bond market. But with the two-year yield currently trading at almost 70 basis points above federal funds, there could be a signal in the market for a rate hike as early as Wednesday.
