US Federal Reserve: On hold... but we still assume a hike ahead

The economist view

As expected, the Federal Reserve held rates at 3.5% to 3.75%. Again, Fed Chair Kevin Warsh was much less forthcoming than Jerome Powell used to be in explaining their thought process. However, there was nothing in today’s meeting and press conference that leads us to change our central case that the Fed will likely hike once this year.

Why not hike?

Warsh did not clearly articulate why they refrained from raising rates today. However, he did say that the soft June inflation print didn’t play much into today’s decision, saying “we are not relying on any one individual piece of data” and that “what the committee care about is trends on the data”.

There was some suggestion in his remarks that higher nominal and real rates over the intermeeting period in market pricing has done some of the work for them. For instance, when asked why rates shouldn’t be higher today, Chair Warsh said, “rates are higher today than they were 42 days ago… market rates have moved up across the Treasury curve” and that the “prices we see in the financial markets is one of the ways [monetary policy] affects the real economy”.

Support for a future hike

A number of things about today’s decision and press conference support the idea that a rate hike is more likely than not at one of their forthcoming meetings:

1. Three members of the Committee voted for a rate hike (Beth Hammack, Neel Kashkari, Lorie Logan), the same members that voted to remove the easing bias from the statement in April.
2. Although the FOMC statement now says little, the description of the economy still leans towards supporting a hike rather than a cut. As it did in June, the statement says economic activity is expanding at a “solid pace”, job gains “have kept pace with the workforce” and “inflation remains elevated.” Warsh later described the economy as showing impressive resilience but that “inflation remains elevated”.
3. The only forward-looking bit of the statement was (again): “The Committee will deliver price stability” which Warsh reiterated many times in the press conference.
4. In the press conference, he said that if inflation continues to be elevated, interest rates could well be part of the solution, but not in isolation.
5. Warsh provided some insight into his reaction function, suggesting that for “any central banker… where the labour markets are more or less at equilibrium” and “underlying inflation is moving higher” would be “more likely to tighten policy”. To us, that points to the potential for a hike in the coming meetings.

Warsh gave a little colour on the discussion

He described the discussion as vigorous, active and robust and centred around four topics/questions (while giving little sense of where the Committee’s views were on these questions): 1) implications of past five years of high inflation; 2)  the economic shocks of recent years and whether these differ in effects; 3) price increases arising from shocks – do these indicate a broader inflation dynamics; 4) monetary policy tools and strategies for achieving stable prices.

Warsh did not describe today as a pause.

Not a pause

Warsh did not describe today as a pause. He said, “if you were to force a description that this was a pause, I would say… financial markets market prices in this intermeeting period, they didn’t pause.”

He talked about the role of things other than interest rates, including the importance of expectations. In that vein, he spent some time reiterating that there was “no soft target” and that the Committee were determined for inflation to hit the 2% target. He did say that the official target was for personal consumption expenditures (PCE) inflation to hit 2%, but that he looks at a fuller set of indicators beyond PCE to better understand underlying inflation. He said the Committee agreed they had the power, tools and authority to deliver on the mandate.

Lack of forward guidance and unfiltered market views

At many points during the press conference Warsh came back to the point that by giving no forward guidance, they were able to observe the markets “unfiltered” view. He said that removing forward guidance would be a transition, but that the market was “learning to play the ball not the referee”. By removing forward guidance, Warsh said markets were not “echoing back what we are saying back to us… they are giving us their judgement” and described the market as a “very accomplished economist”. Since the market moved to price in higher rates in the intermeeting period, we would argue that the ‘accomplished economist’ is advising them to hike.

We don’t think anything in today’s press conference or statement changes our central case for the Fed to hike rates once this year.

Implications for the outlook – still pencilling in a hike

Warsh confirmed he will hold press conferences until the end of the year, giving us more opportunity to hear more about both his thinking and the Committee’s deliberations. For now, though, we don’t think anything in today’s press conference or statement changes our central case for the Fed to hike rates once this year.  The outlook, however, remain dependent on events in the Middle East and future path of energy prices.

The fund manager view

At his first federal open market committee (FOMC) meeting back in June, new Fed Chair Kevin Warsh caught the market by surprise when he made it clear that the Fed’s focus was firmly on the “stable prices” element of its dual mandate, and inflation remaining above target for over five years was not to be tolerated. As a result, the market had begun talking up the possibility of a hike to the Fed Funds rate at its July meeting.

While not fully priced, an implied pricing of around 30% indicated that a not insignificant proportion of market participants felt that the Fed could deliver a surprise hike. The most recent US monthly headline CPI print coming in at -0.4% vs a consensus estimate of -0.1% and a prior figure of +0.5%, and a similar reduction in Core CPI, perhaps tempered that expectation a little. Nonetheless, this meeting was very much viewed as “live”.  

The market reaction to the decision to keep rates on hold was to steepen yield curves dramatically; two-year treasury yields fell by as much as 10bps (0.1%), while 30-year treasury yields rose by a similar amount. Two-year US breakevens rose by around 5bps and five-year breakevens by as much as 8bps. The signal from the market was clear – a perceived reluctance from the Fed to take affirmative monetary policy action, instead relying on the market to do their job for them through higher nominal and real yields, risks inflation getting further out of control.

A lot of the price action took place not on the announcement of the decision itself but during, and following, Chair Warsh’s press conference.

Rhetoric around targeting inflation is one thing, but the market wants evidence of a firm commitment to action. A lot of the price action took place not on the announcement of the decision itself but during, and following, Chair Warsh’s press conference. Warsh outlined their discussions over the preceding two days and gave an insight into their key areas of focus but did not, crucially, provide the market with any of their conclusions. Warsh’s comments implying that the inflation target could change in January likely didn’t help. Repeated references were made to this being a new committee, perhaps one finding its feet and setting out how it intends to conduct its discussions and decision-making processes and reaction function going forward.

The lack of affirmative policy action against the criteria laid out by Warsh has the market questioning the credibility of this new Fed.

However, the messaging was somewhat confusing – the lack of affirmative policy action against the criteria laid out by Warsh has the market questioning the credibility of this new Fed. This is what the market latched on to – and if the Fed is now looking to the market to be a “very good” (though not “determinative”) source of information, the committee should sit up and take notice. The move higher in longer-term yields and the repricing of interest rate expectations (a hike in September is now 70% priced, from being around 100% priced prior to the meeting) suggests that the market is not wholly convinced that this new regime at the Fed is on top of its remit, which “these days means delivering on price stability”.

In terms of market preference, over recent months we have shifted our bias towards yield curve steepening expressions. In my view, the re-steepening of the US treasury yield curve following the Fed meeting has proved beneficial, as has the increase in US breakevens.

Going forward, markets are likely to be driven largely by data and geopolitical developments. However, in a new regime of reduced forward guidance from the Fed, it remains to be seen to what extent the Fed can (or wants to) influence markets, outside of its policy decision dates. We believe this is likely to serve to keep volatility elevated, presenting opportunities for tactical active management.

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