Fed’s Warsh credibility questioned after interest rate decision: analysis

For a Fed chairman who values ​​credibility above all other virtues, the market reaction to Kevin Warsh’s comments on Wednesday must have been painful.

Warsh hosted a press conference Wednesday afternoon after the Federal Open Market Committee voted 9-3 to keep interest rates on hold. It was the second such meeting since Mr. Warsh became Fed chairman on May 22. Investors responded by sharply lowering the likelihood that the Fed would raise interest rates at its next meeting, while also pushing up long-term Treasury yields.

The yield after the press conference is 30 year treasury The yield was the highest since 2007, while the two-year bond yield fell. The probability that the Fed will leave interest rates unchanged at its next meeting rose 20 percentage points to 45%, according to CME FedWatch.

The move suggests that investors believe the Fed may need to act more aggressively going forward as the economy heats up over time, with the Fed not taking immediate action on readings of inflation that Warsh said have been above the Fed’s 2% target for at least 63 months.

Before taking office, Mr. Warsh was harshly critical of his predecessor, Jerome Powell, when long-term Treasury yields rose after the Fed cut the federal funds rate, repeatedly saying the fundamental problem was Mr. Powell’s lack of credibility. Wednesday’s situation was a little different, with the Fed not cutting interest rates but leaving them unchanged. Warsh also suggested Wednesday that the recent rise in long-term interest rates may reflect positive economic news, such as strong business investment.

Still, very few people in the market thought that way.

Longtime Fed watcher John Hilzenrath wrote in a note to clients after Mr. Warsh’s news conference that Mr. Warsh needs clarity on what it will take to finally want to raise rates in the face of stubborn inflation.

“Since Mr. Warsh did not get his message across clearly or explicitly, the bond market blamed him,” Hilsenrath wrote.

Warsh, along with the other eight members of the FOMC, declined to answer reporters’ questions about the details of why he decided that 3.5% to 3.75%, where interest rates have been for several months, was the right place. Mr. Warsh reversed the Fed’s policy by ending a practice known as forward guidance. Past Fed chairmen will give strong indications about where interest rates will go in the future. Warsh believes that forward guidance has made the Fed less flexible and has muddied the signals from the market. As a result, he doesn’t talk much about how he makes decisions.

“While we understand the desire to receive occasional forecasts and comments from our committee, we need to observe the market’s reaction to developments directly and unfiltered,” Warsh said in his opening remarks Wednesday.

At a subsequent press conference, some economists were perplexed.

“Today’s press conference was confusing and often internally contradictory,” Eric Winograd, chief U.S. economist at AllianceBernstein, said in a letter to clients.

Consumer price index data for June showed prices down 0.4%, giving the chairman an opportunity to seize some positive economic indicators. But while Warsh asserted that inflation was still “rising”, he said that factor was “not really” a consideration for him.

The Fed has publicly committed to achieving 2% annual inflation over the long term in its index of personal consumption expenditures, a proxy measure of inflation. Warsh was also less clear about whether he was satisfied with the data, which was 4.1% in its most recent reading, adding that one of the five task forces he appointed to consider reforming the Fed may want to downplay PCE as the central bank’s official goal when it releases its report at the end of the year.

“We’re sticking with PCE for now,” Warsh said. However, “no one knows what we can say about strategy after next January.”

Mr. Warsh’s reluctance to say exactly what would prompt him to raise rates, combined with his indication that he was not committed to the Fed’s reliance on PCE, led some markets to reassess his short tenure.

“All of these points call into question the new chairman’s credibility to bring inflation down,” said Michael Feroli, chief U.S. economist at JPMorgan Chase.

The Fed chair does not alone set interest rates. He is one of more than a dozen votes on the FOMC. Three voters opposed Wednesday’s decision to keep rates unchanged. More indicators could be added if economic indicators do not improve rapidly in the coming months.

“We believe this provides further urgency for the remaining members of the committee to act on their mandate,” Feroli wrote. The Fed chair has never been in the minority on a vote on interest rates.

That puts Mr. Warsh in a difficult situation, and his credibility in the markets and within the Fed itself could be eroded just a few months into his role.