It’s a Different Fed

While the Federal Reserve delivered exactly what the markets expected on Wednesday by hiking its policy rate for the first time since 2023, it also surprised them.  

I believe markets must adapt to Chair Kevin Warsh’s Fed, which I expect will be less patient and less accommodating.  

Indeed, the Fed’s message showed resolve to break inflation, and, in my view, it was an admission that a demand-side shock is contributing to inflation, not just a supply-side shock from higher oil prices.  

In Warsh’s own words, “The economy appears to be strengthening,” despite higher oil prices, higher rates, and elevated uncertainty from geopolitical challenges.

Expectations of future growth

While there were no dissents in Wednesday’s decision to raise rates 25 basis points to a range of 3.75% to 4.00%, most surprising to me was the revision to a deeply buried portion of the Summary of Economic Projections (SEP). All participants currently agree that risks to GDP are balanced or there is a risk of higher growth. No one sees a risk to the downside, a notable departure from the prior version.  

This Fed sees growth accelerating and along with it the potential for higher inflation, and the Fed believes it must act to prevent this pass-through of growth and commodity prices to generalized inflationary pressures.

With Wednesday’s hike fully priced in advance, the biggest question that needed to be answered was what comes next.  We just received the likely path: The median of participants see at least one additional hike in 2026, with only two members seeing no additional hikes. There certainly is potential for a hike at the Fed’s next meeting in October if the data remain consistent with what we have seen over the prior quarter.  For 2027, the median dot also prices an additional hike before a hold and then eventual cuts.

It’s also worth keeping in mind both that the Fed wants to reduce its balance sheet, and that Warsh previously created five task forces. Perhaps if inflation remains elevated, we will see strong recommendations from them toward year end, and with that the potential for shifts the market isn’t even contemplating.

Oddly, the committee does not see a return to 2.0% inflation until 2029. In my Jackson Hole commentary (read it here), I noted the Fed appeared to be both hawkish on inflation while also signaling that so long as the burden of proof was met to suggest a trend to 2%, they could stand pat. Friday’s CPI report firmly broke that burden of proof.

Disinflation evidence needed

From here, that same burden of proof toward disinflation will remain; unless the Fed sees signs of inflation clearly and at sufficient speed returning toward 2%, it will continue to hike. This does not mean hope of moving toward target; it means progress. For example, there is much chatter of potentially greater productivity enhancing growth. For now, this remains hope and is unlikely to sway the Fed.

The most notable question that remains: If this Fed wants a “timelier” return to 2% inflation and doesn’t see this return as occurring until 2029, then why only raise the policy rate by 25 bps? When asked about this disconnect, Warsh fairly suggested these projections are not his own, but those of FOMC members. We must consider: What does Warsh believe and how willing will he be to push the committee in the direction of potentially more rate hikes than are currently priced?  If we see high-priced oil bleed into inflationary pressures, I could envision a 50-bp hike becoming a base case.  

I continue to believe unless inflation returns to target, this Fed will force a slowdown in demand to meet their price stability mandate. The Fed did not raise rates because the markets demanded action; the Fed acted because it is seriously concerned about inflation.  The economy is strong, and the neutral rate is likely to be revised higher toward 4% over time in recognition that the extreme low-rate regime we had been in is becoming a relic of the past. The question becomes, how far above neutral – a level that is neither accommodative nor restrictive – must we move in order to bring inflation to 2%?  This Fed is likely to find that answer, and it may be higher than markets currently expect.

The markets’ initial reaction seemed to express that they don’t like this new Fed, but it has never been the Fed’s job to be loved by markets.  Further, Warsh has been clear from the start that the relationship is tenuous at best between markets and the Fed. He also signaled his view on the direction of monetary policy with the statement that the Fed had just “removed a dose of accommodation so that financial and credit conditions would be more consistent with our ultimate objectives.” Emphasis on “a dose of accommodation.” As the markets digested the move, the initial reaction has faded, and markets appear to believe the Fed can fight inflation without the need to destroy demand; this is a delicate balance and the risks to the downside are real.  

This is a different Fed. Markets must adapt.

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