The FOMC left rates unchanged at 3.5% – 3.75% by a 9-3 vote at the July meeting (28-29 July). The rationale is to balance steady (still solid) economic and job growth against sticky and elevated inflation driven by the supply and energy shocks which are still expected to be short-term.
However, most market participants complained that Fed Chair Warsh came out with a lot of bluster but with no coherent messages for the economy, inflation, and, hence, monetary policy guidance. The market also did not seem to buy his hawkish tone on reining in inflation and, hence, was left without any conviction on the Fed moves, though there is a weak consensus on rate hike(s).
What’s going on in Mr. Warsh’s mind, and what are the market implications?
Economic conditions and outlook behind the rate decision:
- Price pressures remain above the Federal Reserve’s 2.0% goal due to supply shocks and energy costs.
- Economic activity continues to expand at a solid pace alongside strong productivity and capital investments (esp. in AI and tech).
- Job gains roughly match workforce growth, leaving the unemployment rate little changed. Wage gains still healthy at over 3.0% YoY.
- Consumer spending remains steady, supported by household dissaving and steady income growth.
Rate hike expectation remains
The big question is whether we are entering a period where inflation will continue to trend higher? There are arguments to suggest we are:
- Geopolitical disruptions to trade, investment, and supply chains seem to have become more frequent.
- Climate change, protectionism, and the need to spend on artificial intelligence can all contribute to
upside inflation risks.
All these are factors in the Fed’s policy reaction function. The short-term swing factor for the inflation and policy outlook is of course the Middle East war and its energy shock. Hence, there is no strong market conviction on the Fed policy outlook other than a weak consensus of interest rate hike(s).
Given the still steady US economy and labour market on the back of sticky inflation and geopolitical risk, one rate hike in September by the Fed as an insurance hike is the market’s base case. But if the oil shock from the Iran war lingers on and intensifies short-term inflationary pressures, there may be one more hike in 4Q 26, as the Fed’s move is data dependent.
The Fed’s ambiguity
While almost everyone in the market complained about the Fed’s lack of clarity on its policy outlook statement and forward guidance, I have a different read on (hence, with different market implications from) Chair Warsh’s “confusing” messages after the July FOMC meeting.
Warsh may be using a strategy that central banks typically used in the 1980s and 90s – constructive ambiguity or secrecy – to maximise the impact of monetary policy on the economy through policy shocks. The shift to policy transparency through forward guidance only started in the late 1990s and early 2000s.
Time will tell if this is correct, but Mr. Warsh’s policy intentions/statements (he repeatedly said that he wanted to ditch the practice of forward guidance) seem to be moving in that direction. If this is true, that means there will be more volatility at the short end of the yield curve (thus creating more equity market volatility) and a higher term premium at the long end. The Treasury yield curve will be structurally steeper going forward.
While Mr. Warsh adopted a hawkish tone at the FOMC meeting by stressing the significance of managing inflation, the market either did not buy that or was too confused to arrive at a conviction. This can be seen in the bearish steepening of the Treasury yield curve right after the meeting (on 29 July), with the front-end falling by 2 bp while the long end rising by 14 bp.
The rise in the long yield was likely driven by an increase in term premium due to the lack of forward guidance. If this increase reflected market confusion, it would underscore my argument above that the Fed might be moving back to a constructive ambiguity or secrecy policy approach again by abandoning forward guidance.
