Fed hints at higher rates

New Fed Chairman Kevin Warsh may have upset his boss today! The message from the FOMC was that higher rates may be coming, despite Trump’s call for lower rates and the President’s apparent hopes that his appointee would deliver. The 2-year Treasury yield rose 13bps and markets are pricing in 100% certainty on at least one rate hike before year-end.

Economists have been looking for higher rates for some time because core US inflation is stuck near 3% and recent jobs data have been on the strong side. The markets reacted strongly today because Warsh did not scotch that idea. Instead, he emphasised his commitment to price stability while the ‘dot plot’ projections from the FOMC members suggested the Fed Funds rate will be at 3.8% at end-year vs the 3.5-3.75% range today, which puts the 'effective' Fed Funds rate at 3.63%.

That said, Warsh was at pains to emphasise that he personally did not participate in the projections (he doesn’t believe in them and wants to drop or change them), and he also implied that the committee was fairly balanced on the next move.

If oil starts flowing freely and US pump prices come down, inflation pressures should recede but the gain in consumer purchasing power could make the economy look even stronger. The key will be the unemployment rate. If that falls to 4% or lower (4.3% latest) a rate hike is virtually certain. Only remarkably good inflation figures would prevent that. If unemployment stays above 4.3%, however, the Fed may well not pull the trigger.

Warsh’s ‘model’ of how the economy works is still opaque. He doesn’t like the so-called ‘Phillips Curve’ – the view I just expressed that lower unemployment risks higher inflation, even though that is standard dogma at the Fed and for most of the FOMC committee. He did mention one of his heroes – the monetarist economist Milton Friedman. Warsh didn’t talk about money supply growth, though it is actually accelerating so certainly doesn’t offer any cover for rate cuts. Warsh mentioned that high interest rates are crimping the housing market but acknowledged that the rest of the economy is strong.

Overall, it was an assured performance from Warsh at his first press conference but the committee will not let him depart much from the standard orthodoxy, at least for now. Warsh promised five ‘task forces’ to report by end-year on different areas of Fed monetary policy activity: communications, the balance sheet, data inputs, the implications of AI and productivity and the Fed’s policy framework. Doubtless he hopes to steer thinking in his direction over time.

That doesn’t mean he will be dovish. But we can assume that he will take what opportunity there is to avoid raising rates if he can. That opportunity might arise from talking tough without pulling the trigger (essentially today’s story), pointing to AI and faster productivity growth as obviating any need for tightening, and/or using changes to the balance sheet as an alternative to rate hikes.

Time will tell. Meanwhile, the strength of both the economy and inflation support our view of ‘higher for longer’ for both 2-year and 10-year yields. We see the next policy move as likely up but it may not come this year.

John Calverley,

Chief Economist