Why the Fed decided not to cut interest rates
(CNN) — Economists and analysts kind of lost their minds about what they heard from new Federal Reserve Chairman Kevin Warsh Wednesday. Or, more precisely, what they didn’t hear.
Warsh has elected to break with his three immediate predecessors’ efforts to make the Fed more talkative and transparent. The problem, Warsh argues, is that old approach transformed the market into a prediction engine for Fed rate decisions. Lest the Fed send markets into chaos, central bankers became obligated to follow markets’ predictions – locking the Fed into decisions even if the economy changed.
In Warsh’s parlance, the market was playing the referee, not the ball.
But the lack of chatter isn’t sitting well with markets.
The Dow had its worst day in 15 months Wednesday. The 30-year US Treasury yield rose to its highest level in 19 years. The benchmark 10-year Treasury yield is very nearly at its highest level of Trump’s second term. Stocks are bouncing back just a bit Thursday. Bonds are not.
The predominant thesis about the market reaction is that Warsh’s tough talk on inflation when the Fed opted to hold rates steady and neglected to lay out a strategy for future hikes gives him (and the Fed) a “credibility” problem – Fedspeak for the market losing faith that the bank will take the necessary actions to fulfill its dual mandate to combat inflation and boost employment. Some more cynical commentary called into question whether Warsh can act as a good steward of the economy when the man who hired him, President Donald Trump, has called vociferously for lower interest rates despite stubbornly high inflation.
But, under scrutiny, it’s not clear that argument holds much water: The Fed did exactly what the market expected on Wednesday.
That’s why the more likely reason for the market freakout is simpler: New Fed chairman, new lingo, new rules. That’s going to take an adjustment period, and markets are figuring out how to speak Kevin Warsh’s language in real time.
The ‘credibility’ argument
Warsh, on inflation at least, is unafraid to talk a big game. He defiantly planted his stake, calling any inflation above 2% unacceptable.
“We will deliver the 2% inflation target,” Warsh said Wednesday. “We’re going to be judged by how we perform, and that’s what we intend to do.”
But Warsh and the Fed didn’t take action on Wednesday after a 9-3 vote to keep rates steady. And he was reluctant to acknowledge a hike might be warranted in the future if inflation doesn’t come down.
That’s why many market analysts and economists are suddenly calling into question Warsh and the Fed’s “credibility.”
That sounds harsh, but if the Fed says one thing and does something else, the market gets confused and can grow volatile – like it did Wednesday.
The problem with the credibility argument is that the market expected the Fed to keep rates steady. The CME Group’s FedWatch tool gave the Fed a two-thirds chance of holding rates between 3.5% and 3.75% before the meeting. Kalshi put the chance of holding at 74%. And that’s what the Fed did.
Also Warsh has repeatedly said the Fed wouldn’t provide an outlook on its future rate decisions.
In other words: How can the Fed fail to back up its expected action when it did exactly what most market participants expected and said would happen?
The hawkish Fed argument
Another possibility for the market’s moves: It’s listening very closely to Warsh and hearing him loud and clear.
Warsh dropped a lot of hawkish hints in his press briefing Wednesday. He doubled down on the Fed’s 2% target, unsolicited. He argued that last month’s significant drop in inflation didn’t satisfy the Fed that the inflation battle was won. He mentioned multiple times that the significant surge in AI spending by businesses has made the Fed’s job of controlling inflation harder.
And a remarkable three dissents to the Fed’s decision to hold (they favored a rate hike) sent a strong message to markets that the bank would probably need to hike interest rates soon – perhaps as soon as its next meeting. The CME FedWatch tool currently puts a chance of a hike at the September meeting at 60%.
In other words, markets are doing exactly what they’ve always done: reading the Fed’s tea leaves, whether Warsh likes it or not. Perhaps Warsh wasn’t nearly as opaque as the market commentators argue he was.
The market confusion argument
A third possibility: The market is adjusting to a massive change in how the Fed communicates.
The markets’ interpretation of the Fed’s interest-rate decisions has gotten cloudier because Warsh has purposefully chosen to give away less. Economists have figured out some of his lingo: “Family fight” means “a respectful disagreement among voting members.” Other terms, like “watchful thinking, not watchful waiting,” continue to elude many folks.
So markets have taken matters into their own hands. As Warsh noted repeatedly Wednesday, that’s not necessarily bad.
The Fed is not the only player in the inflation-fighting game: Markets get a say, too. They set interest rates in the form of bond yields, which influence the volume of lending and can speed up or slow down the economy. Just like the Fed’s target rate.
Right now, bond yields are higher than the fed funds rate suggests they should be. A lot higher. The two-year US Treasury yield, which usually (though not always) follows the fed funds rate in lockstep, is around 4.27% – way higher than the 3.5% to 3.75% Fed target.
In a way, the market is doing the Fed’s work for it.
The central bank still may need to raise rates, and there’s an argument for doing it now before inflation gets out of control. There’s also an argument for waiting as long as possible because a lot of the inflation problem is caused by the Iran war, and oil prices have sunk as fast as they’ve risen, muddying the inflation picture. The labor market is solid but weaker than in recent months, and higher rates could hurt the recovery.
Trump’s insistence on lower rates isn’t helping matters, and cynics argue that Warsh doesn’t want to make the president angry.
But Warsh deserves the benefit of the doubt for now. As much as he’s learning how to do his job, we’re also learning how to listen.
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