Hawkish vibe at the Fed

Inevitable heightened volatility of expectations in a changing monetary policy regime

Is new Federal Reserve (Fed) Chair Kevin Warsh a dove after all? Financial markets read his second press conference as dovish: Expectations of a near-term rate hike fell, long-term bond yields rose, the U.S. dollar weakened and so did stocks.

Judging from the first wave of analysis and reports, the dovish impression seems to stem from two things: What Warsh did not do, and what he did say.

What he did not do

Warsh did not lead the Federal Open Market Committee (FOMC) to hike interest rates. This was not a big surprise, as most analysts and financial market participants assigned less than even odds to a July rate hike. Still, several reporters pressed him hard on this during the Q&A: Inflation has been above target for five years now. You keep saying you are committed to bringing it back down to 2%. Then why have you not raised rates, especially given that you see the growth outlook as robust?

Warsh’s reply was weak. He pointed to the marked rise in market bond yields since the June press conference, which has resulted in a tightening of financial conditions. His argument, however, was not fully convincing. He said that “the reduction in forward guidance may have been a factor” in pushing up yields, as financial markets started to focus more on economic fundamentals than on the Fed. And later he added, “Monetary policy matters not just by what we say or even what we do. Monetary policy matters by how it affects the real economy. And these prices that we see in financial markets is one of the many ways in which it affects the real economy.”

This seemed like an oblique way of taking credit for the rise in market yields; by removing forward guidance, the Fed pushed investors to price more appropriately the macro environment, which resulted in a tightening of financial conditions. This is probably true, but I think there is more to the story; financial markets had also priced a more hawkish Fed, based on the strong anti-inflationary rhetoric which Warsh deployed in the June press conference.

What he did say

Some analysts and commentators seemed to interpret the reference to higher bond yields as, we don’t need to hike, the markets have done it for us. It was one of three statements that were read as dovish. The second was where Warsh was asked about the inflation target. He replied that formally Fed policymakers are still committed to 2% on the Personal Consumption Expenditures (PCE) deflator, but that in their assessment, they are looking at a broader set of inflation indicators. Some commentators interpreted this as a desire to find a more forgiving inflation metric that would justify unchanged or even lower rates. The third was when Warsh indicated that interest rates would be part of a potential policy response, but did not say that they would be the main instrument for tightening.

And so Warsh has been quickly branded as a dove by many analysts and commentators. It’s an impressive display of newfound hawkishness from the same observers who did not bat an eyelid when Jerome Powell cut interest rates by 75 basis points (bps) late last year in a very similar macro environment, or indeed when he cut by 100 bps during the last four months of 2024, with PCE inflation above target and rising.

I think it is a stretch to conclude from all this that the new Fed Chair is just another dove. Let me offer a different reading.

There was a genuine, solid argument for not hiking rates this month. Inflation remains above target, but it’s not dangerously high, and the latest core readings do not show much evidence of high energy prices bleeding into stronger broad-based inflation pressures. Given that Warsh assumed the Fed leadership barely two months ago, there is value in taking advantage of this window of opportunity to deepen the debate within the FOMC and build a consensus for a shift in policy.

Having kept rates on hold, the best way for Warsh to reinforce a hawkish message would have been to indicate that an increase in policy rates is likely in the next few months. But this would have amounted to clear forward guidance for market expectations, something he has pledged not to do.

Warsh did make one hawkish statement, which seems to have been largely ignored. He noted that “For some households, businesses and market professionals, five years of high inflation have left a mistaken impression that’s hard to shake,” namely, that the Fed has de facto increased its inflation target. He continued with, “Let me reiterate, there is no soft inflation target. There is no soft implicit target. Not on this committee’s watch. There’s only a target and it’s 2%.” That's a very important clarification that addresses a real credibility problem.

Heightened volatility of expectations

My take is that we are experiencing a heightened volatility of expectations, which is inevitable in this change of monetary policy regime. On “Day Zero,” many suspected Warsh would be dovish simply because he’s a U.S. President Trump appointee. His hawkish stance in June therefore came as a surprise, and now the lack of policy action in July has rekindled the initial suspicions.

Beyond reiterating his commitment to price stability; however, there is not much that Warsh can say at this stage. He cannot indicate a tightening or easing bias because he has abandoned forward guidance. He cannot be too explicit on inflation measurements or monetary policy tools because he does not want to pre-empt the work of the task forces.

Warsh is driving a set of important changes at the Fed, and the transition is not without difficulties for both the Fed itself and financial investors. Financial markets will continue to try to divine what the Fed will do next – that s only natural. The Fed needs to figure out how far it can go in explaining its reaction function without having it quickly translate into a forecast of policy moves.

Nudging policy rate upwards

It all boils down to the actions. As I have been arguing for quite some time, I believe that the neutral fed funds rate is higher than current levels, around 4%. If the Fed is serious about bringing inflation back to target, it will need to nudge the policy rate up, and I think the three dissents we have seen in July point in that direction.

Bond market yields have already started to move to levels more consistent with the macro-outlook and with the pressures coming from loose fiscal policy. Post the press conference, we saw a pronounced steepening of the yield curve, as markets digested higher policy uncertainty and priced the potential for higher inflation. I continue to believe that 10-year yields on U.S. Treasuries are likely to be range bound, but as the Fed and markets take the measure of this new policy regime, we will have an additional source of volatility on top of what is already generated by uncertainty on economic trends, technology, and geopolitics.

Sonal Desai, Ph.D. is the executive vice president and Chief Investment Officer for Franklin Templeton Fixed Income at Franklin Templeton. Originally published in the Franklin Templeton Insights page.

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