Warsh’s debut eases independence concerns, but weakens the ‘Fed put’

Wednesday’s Federal Reserve (Fed) press conference was one of the most eagerly awaited in a very long time. Kevin Warsh’s debut as chair, after three weeks in post, was not an easy one. He faces inflation well above target, buoyant risk markets, and lingering doubts about how much influence President Trump might exert on him – this will be an ongoing theme. Our take is that the conference was, on balance, a positive one, where some questions were answered, others were not, and some new questions arose.

First, early indications are that Warsh is unlikely to be heavily influenced by President Trump’s desire for lower nominal rates. His tone was hawkish on inflation, with polite criticism of the Fed missing its 2% inflation target for too long, and an emphasis on “price stability” throughout. This is important, indicating that the market reaction (chiefly a sell-off in short end US Treasuries) is a “genuine” one, reflecting what markets think about the path of monetary policy and the economic landscape going forward, rather than Fed independence considerations.

Second, it is clear to us that the identity of the Fed chair would have had little impact on the hawkish shift by the Federal Open Market Committee (FOMC). This is because the inflation outlook in the US is different from the situation in Europe and the UK. European central banks are dealing with a supply shock, the question being whether it will spread to other parts of the economy. Given the demand side of the equation is relatively weak, and the softening of labour markets has created some slack in the economy and a reduced probability of second round effects via higher wages, we believe this shock is unlikely to spread.

However, in the US, the supply shock is less cushioned than in Europe and the UK, resulting in faster pass-through (inflation stands at 4.2% in the US, 3.2% in the Eurozone and 2.8% in the UK). More importantly, the US faces greater demand side pressures that might require tightening, with AI investment and a solid labour market being two tangible examples.

Third, the market reaction to demand higher yields at the very front end is justified. While it is difficult to determine how many basis points each specific factor contributed, it seems to us that the short end reaction would not have been too different had Jerome Powell still been in charge. Markets, therefore, reacted to an FOMC that is more likely to raise rates at some point this year than it was a month ago, rather than responding just to a change in the Fed chair. Looking at longer maturities, the bear flattening of the US Treasury (UST) curve in US hours has partially reversed, with 10-year USTs at 4.45% at time of writing; however, 30-year yields finished the day slightly lower yesterday and have rallied a bit further today.

Clearly, markets believe Warsh when he says he’ll bring inflation down to target and that the Fed will continue making decisions based on data and not politics; otherwise these moves would not have happened.

Fourth, Warsh has launched a number of taskforces that will bring potential changes to the way the Fed operates. It is difficult to argue that data series such as non-farm payrolls (NFP) are a great input from a statistical point of view; they are not timely and revisions are sometimes larger than the initial estimates.

In that sense, a review of some of these is welcome, but it needs to be handled carefully. Economists and forecasters have models that use these data series and derive statistical relationships between them based on history. If there is a “structural break” in the data because of a change in the way data is calculated, models need to adapt to it. This might take time as forecasters try and derive new statistical relationships and for a period at least, forecasts might therefore be subject to higher uncertainty and be less precise.

On other taskforce topics, we were reassured that despite there being a taskforce in charge of revisiting the Fed’s framework for understanding inflation, Warsh was very clear that the 2% inflation target is not up for revision until it is accomplished. This feeds into the Fed independence topic and the reaction of the long end.

Finally, there was a very interesting comment about the interaction between markets and the Fed’s decisions. Warsh stated he believes that financial markets perform best when they react to incoming data, rather than considering how the Fed will react to that same information: “The more markets focus on what is actually happening in the real economy – judging what constitutes good data versus weaker data – the better they can price in both the most likely outcomes and tail risks.”

In our view, this means the so-called “Fed put” has weakened. Warsh is saying that markets work better when left to price risks on their own, which is the exact opposite of the Fed intervening when equities sell off. While we have no doubt the Fed would intervene if financial stability were at risk, from now on, when markets look shaky, the Fed is less likely to provide support. This is consistent with Warsh’s preference for reducing forward guidance, exemplified not least by his decision not to contribute to the latest ‘dot plot’ of FOMC members’ personal interest rate projections – Warsh believes the Fed has overstepped its mandate here in the past.

After the long wait for Warsh, the markets finally have some answers. The main one is that the 2% inflation target remains unchanged and will be pursued vigorously by an FOMC that is noticeably more hawkish than it was a month ago, driven by the latest data. However, other key questions remain unanswered, one of the most important ones being whether Warsh thinks current rates are restrictive. New questions also arose regarding potentially big changes to the way in which the Fed looks at inflation, data and balance sheet management, among others.
Given these unanswered questions, we would not be surprised to see some volatility as markets seek to answer these questions and adjust to operating on their own, with less Fed guidance and intervention.

We are reassured that, despite the relatively big changes that may be on the horizon, these are likely to be well thought through and aligned with the same objectives the Fed has had in the past. With the Iran conflict and Warsh’s Fed debut moving out of the way, a quieter summer period might allow fixed income investors to enjoy their well-earned yields and well-earned leisure time in peace.