- Key insight: After two press conferences with scant policy explanations for forward guidance, market participants and banks are questioning the credibility of the Warsh-led Federal Open Market Committee to raise rates to combat inflation.
- Expert quote: "The vacuum from Warsh declining to give a reaction function — not just forward guidance — means the market is going to fill in the blanks. When they fill in the blanks, they're going to err on the side of caution." — Derek Tang, CEO of Monetary Policy Analytics.
- Forward Look: Forecasts about the Fed's next moves range from no hikes the remainder of this year to as many as three hikes over the course of the rest of the year.
Federal Reserve Chair Kevin Warsh said he wants to change the central bank's relationship with financial markets. Just two interest rate meetings into his term, his approach is already altering markets' perceptions of the central bank.
The driving force behind this shift is Warsh's communication — or
"If he's saying nothing, it just means that there's going to be a lot of different views on where the Fed is headed and what it means," said Mark Zandi, chief economist of Moody's Analytics. "There's going to be a lot more uncertainty and volatility in rates. That's the primary reason why long rates are higher and why the term premium is gapped out. Investors are just lost."
Guneet Dhingra, head of U.S. Rates Strategy at BNP Paribas Securities, said the market response reflects a waning confidence in the Warsh-led Fed's willingness to tamp down on inflation.
"The market is challenging the credibility of the Fed's mission statement to control inflation," Dhingra said. "The June FOMC meeting began with a very strong emphasis on price stability, but the conversation about how to achieve that goal was lacking in July. Actions speak louder than words and the words did their part in June, but the action expectations were not met in July."
Last week, during his second post-Federal Open Market Committee
Most market participants expected the Fed to hold the target range of the federal funds rate steady heading into the meeting, but the hours immediately after Warsh's remarks showed a wave of repricing activity that drove up yields on 10-year notes and 30-year bonds by eight and nine basis points, respectively.
Treasury yields, especially those for longer-dated bonds, are impacted by a host of factors, including economic growth, borrowing demand, labor force participation and even demographic changes. It is difficult to discern exactly how much of the change in yields was attributable to the Fed's inaction or Warsh's commentary; it's also true that Warsh is in the early days of his tenure, and he and markets may take some time to understand each other.
Still, the market takes signals from the Fed whether the institution wants it to or not.
Derek Tang, CEO of Monetary Policy Analytics, said markets have responded prudently to the lack of clear guidance by adopting a more conservative stance.
"The vacuum from Warsh declining to give a reaction function, not just forward guidance, means the market is going to fill in the blanks," Tang said. "When they fill in the blanks, they're going to err on the side of caution."
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During last week's press conference, Warsh said, in general, his reaction function is to favor tighter monetary policy when "underlying inflation" is moving up and the labor market is "more or less at equilibrium." He also said that inflation is too high and the positive consumer price index report from June had "not much" to do with the FOMC's willingness to leave rates unchanged. But he also said that he is looking at more than the Fed's stated inflation target of 2% growth in the personal consumption expenditure index as a metric for success. Together, the statements painted a confusing picture of the FOMC's driving strategy.
Warsh also reiterated the importance of the Fed following markets instead of markets following the Fed — a stance that would support a rate hike to align with changes in bond yields. But he deferred several opportunities to explain why the FOMC was keeping its benchmark rate unchanged when its market counterpart, the 2-year Treasury yield, has increased by the equivalent of three rate hikes since the beginning of the year.
Instead, he praised the market's reaction to real-time economic data and characterized the changes as the markets doing the Fed's work for it.
"Market participants are learning to play the ball, not the referee — and market prices will continue to respond in the direction and magnitude they see fit," Warsh said in his opening remarks for the press conference. "This is, in my view, a change for the better — and we are just getting started."
The concern about the Fed falling too far behind market rates is that it could create the conditions for the Fed at some point to have to raise rates quickly to catch up, as it had to do in 2022. That raises the prospect of a disruptive moment for banks or other parts of the financial system; the failure of
Warsh acknowledged that there could be some bumps along the way as market participants adapt to this new normal, but he maintains that the change will ultimately be for the better.
"Markets and market participants, and reporters, have learned to devour all that information so I take seriously that the pullback of forward guidance requires some transition," Warsh said during the
For now, there is a wide range of forecasts about what the Fed will do with interest rates for the remainder of the year. In an
In their note, Bank of America global economists Claudio Irigoyen and Antonio Gabriel cast the Fed's approach to the rest of year as a litmus test for its willingness to address inflation.
"The Fed is facing a growing credibility problem as the market will continue to test its resolve to deliver price stability," they wrote. "Absent a run of dovish data in the intermeeting period, it is imperative for the Fed to pass the September test by hiking rates and delivering an internally consistent narrative."
