Warsh finally gives markets much needed clarity

Kevin Warsh’s Jackson Hole speech went a long way, in our view, towards restoring some much-needed credibility to the Federal Reserve’s (Fed’s) reaction function and its commitment to the dual mandate.

The recently appointed Fed Chair Warsh needed to provide greater clarity on how the central bank intends to respond to elevated inflation. While he had repeatedly committed to price stability and a return to the 2% target, he had offered relatively little detail on how he planned to achieve that objective. Until now.

Several comments from the speech helped set the tone for what we can expect from the Fed going forward. Although Warsh acknowledged that the Fed’s task forces have yet to complete their work, he outlined several principles that will guide his policy approach. As expected, forward guidance will be limited. More importantly, he did provide greater clarity on the principles that will guide monetary policy. From the seven he outlined; we look at the two referencing the dual mandate.

1. Maximum employment remains equally important. Achieving both sides of the mandate over the medium term is not an either/or proposition.
2. The 2% inflation target is firm. There should be no misunderstanding: the Fed’s price stability objective of 2%, as measured by personal consumption expenditures (PCE), is a fixed target. It is the Fed’s job to deliver stable prices.

On the labour side of the dual mandate, Warsh appears relatively comfortable. He characterised the labour market as stable and consistent with full employment, noting that the unemployment rate remains low by historical standards and has changed relatively little in recent years. He also reiterated that he would be hard pressed to describe broad financial conditions as restrictive.

It was his discussion of price stability, however, that we found most insightful, and that gave the market its clearest read yet on how he will assess inflation going forward. Notably, Warsh does not place undue weight on wage inflation. Instead, he prefers to look beneath the headline PCE number and assess the breadth of inflation across its individual components, finding it "instructive to disaggregate the 199 individual components of the PCE price measure." Inflation has improved materially from its post-pandemic highs but remains notably more widespread than it was in the two decades preceding the pandemic. More recent data tells a similar story: inflationary pressures are easing but remain elevated. Over the past 12 months, 54% of goods and services in the PCE basket rose by more than 3%. Warsh also highlighted that the recent rise in commodity prices is a trend to watch, with the key question being whether it signals renewed upside inflation risk, and, more broadly, whether more than five years of elevated inflation have begun to shape expectations.

Holistically, the market got what it had been looking for: real clarity on the framework that will guide policy. Warsh laid out a simple standard for judging it: the Fed bears responsibility for 65 months of sustained, elevated inflation, and "must be confident that underlying inflation is moving towards its objective clearly and at sufficient speed. If not, there is more work to do."

In terms of market reaction, we had two possible outcomes in mind: Firstly, had the market viewed his comments as insufficiently committed to fighting inflation, we would have expected a bear steepening of the Treasury curve, long-end yields rising relative to the front end as investors demanded greater compensation for inflation and policy uncertainty. We note that this was broadly the reaction following his July speech, when the 2s30s curve steepened by approximately 15 basis points (bp). Secondly, bear flattening would suggest greater confidence that the Fed is prepared to tighten policy sufficiently to contain inflation, with the front end of the curve bearing more of the adjustment.

Following the speech, market expectations for a September rate hike increased from roughly 35-60%, suggesting greater confidence that the Fed is prepared to use its policy tools to contain inflation and deliver on its mandate. The Treasury market sent much the same message. Rather than the bear steepening that followed Warsh’s July remarks, the curve bear flattened by approximately 10bp.

The reaction wasn’t just confined to rates. Commodity markets were also weaker, led by gold pulling back from recent highs, consistent with a market pricing in a more resolute Fed and reduced hedging demand against inflation risk. Taken together, the rates and commodity moves pointed to a broad-based repricing of the Fed’s credibility.

The conclusion is relatively straightforward: the market came away from Jackson Hole with greater confidence in the Fed’s inflation-fighting credibility and, importantly, a clearer understanding of Warsh’s reaction function. That confidence, however, comes with a caveat. Given the standards he has now set and subject to any last-minute surprises in the data between now and the Fed’s September meeting, there’s little room left for him to justify delaying a September hike. Failure to act, absent a clear deterioration in the data, would call into question the very framework he just laid out – and with it, his own credibility as well as the Fed’s. In such a scenario, we must be prepared for a market reaction that mirrors his post July speech, with the curve bear steepening as investors once again demand a higher premium for inflation and policy uncertainty.