Fed Chair's Plan Could Reshape Interest Rates This Year
Credit: New Fed Chair Kevin Warsh could have an outsized impact on policy in the second half of the year.
KEY TAKEAWAYS
-
The Federal Reserve under Kevin Warsh is shifting to a less predictable communication strategy, which could make markets more reactive to economic data.
-
Inflation remains a key concern, and traders anticipate rate hikes later this year.
-
Warsh’s five task forces are reviewing major aspects of Fed policy, which could lead to significant long-term changes.
The Federal Reserve’s new chairman, Kevin Warsh, has big plans for the central bank—and markets will be hungry for clues on his overhaul in the next few months.
The Fed will no doubt grapple with its regular policy debate: should it keep interest rates flat, raise them if the Iran war’s inflationary impact lingers, or perhaps cut them if it fades?
But there’s a bigger debate underway: how should the Fed conduct policy beyond 2026? The potential overhaul could impact household borrowing costs for years to come, and Warsh has kicked off the process with a series of task forces.
Some changes are already visible. The Warsh-led central bank is saying a lot less, with a far shorter Fed statement devoid of any “forward guidance.” Warsh appears keen on keeping markets guessing, a major shift for investors who’ve long been accustomed to the Fed giving hints about its next steps.
“Taken together, the message is clear: the Fed is moving toward a more reactive, less prescriptive communication strategy,” wrote Michael Gapen, chief U.S. economist at Morgan Stanley.
The upside is the Fed can be more nimble as the economy changes—and markets can read less into Fed speeches and more into hard economic data. Markets “perform best when they react to incoming data,” rather than figure out how the Fed may react, Warsh said in his June 17 press conference.
The downside is that a less predictable Fed could make markets more volatile, analysts caution.
The Fed’s ability to guide markets and the public is “one of its most powerful tools,” wrote Barclays Chief U.S. Economist Marc Giannoni. It helps markets, businesses and households make decisions about future spending, Giannoni wrote, and cutting back on that guidance may not be worth the cost.
“Without guidance, markets risk mispricing policy intentions, increasing market volatility and complicating policy execution, especially given that monetary policy works largely through expectations,” Giannoni wrote.
Hike or No Hike?
Though Warsh offered little firm guidance, markets are preparing for rate hikes.
It is partly because “the Fed’s inflation problem has gotten unambiguously worse,” according to Aditya Bhave, an economist at Bank of America. Inflation is now hovering around 4%, double the Fed’s target and marking the latest shock after last year’s tariffs.
“The Fed was willing to look through the tariffs, but it is losing patience after the latest round of supply shocks,” Bhave wrote.
The little guidance that Warsh gave this month centered around bringing inflation back to 2%—a message markets took as hawkish. The Federal Open Market Committee also leaned hawkish, with half of its 18 members suggesting in their projections that they’d favor hiking this year.
Other analysts see the Fed keeping rates flat this year.
“The other half of the committee doesn’t think the Fed will hike. We agree with them,” wrote James Knightley, chief international economist at ING, adding that “a lengthy pause is our call.”
The inflation picture should “improve markedly over the next 12 months,” Knightley wrote, with gas prices already falling and airfares likely to follow.
He also cautioned that the May jobs report, which showed U.S. employers added 172,000 jobs, may be overstating the labor market’s strength. Consumer sentiment about their job prospects is “bleak,” he noted.
“While the improving jobs numbers are great news, some caution is warranted,” he wrote.
Task Force Delays?
Analysts are also closely watching for news from the five task forces Warsh announced, as they could signal major changes ahead.
The “task force is strong with this one,” wrote Oscar Munoz, head of U.S. economics at TD Securities. The changes are likely to be gradual, but the scope of the five task forces is “likely to leave investors nervous about large changes to Fed’s policy,” Munoz wrote.
One covers how the Fed communicates, including the changes that Warsh already implemented. Another is expected to analyze how to measure the economy in the freshest possible manner. A third is on the hottest topic in economics—productivity and the job market as artificial intelligence takes hold. A fourth will review the Fed’s basic theory of how inflation works.
It could all mean any potential Fed rate hikes are postponed or tamped down.
“We think this review process is likely to delay major policy adjustments as the Committee reassesses its framework and tools, and any lack of consensus among policymakers could further slow implementation, ” wrote Ulrike Hoffmann-Burchardi, chief investment officer for the Americas at UBS.
The task forces could give Warsh a chance to “punt” on interest rate policies for a while longer, wrote Derek Tang, CEO and co-founder at Monetary Policy Analytics.
Balance Sheet
The fifth task force could make markets particularly jittery: the future of the Fed’s $6.7 trillion balance sheet. The staggeringly large number stems from the Fed’s massive interventions in bond markets after the 2008 and 2020 crises, as the central bank sought to calm panic and keep rates low by buying bonds in bulk.
The Fed has slashed its bond holdings from a peak of nearly $9 trillion in 2022, but they remain sizable nonetheless. Warsh has called for unwinding that gradually, arguing that the Fed’s large footprint in markets “disproportionately helps those with financial assets.”
Cutting back is far from easy, since markets are used to lots of cash sloshing through the banking system. Though not immune from stresses, an ample supply of cash can help keep conditions in the plumbing of financial markets stable—without disruptions that spill over into the broader economy.
After the 2008 financial crisis, Congress and regulators also sought to make banks safer by requiring them to keep far more cash stashed away as reserves. Any changes to those rules could pose trade-offs to the financial system’s stability and would take at least several months, analysts say.
But without taking on that work, it’ll be hard for Warsh to make the Fed’s balance sheet a lot smaller, wrote Joseph Abate, a U.S. interest rate strategist at SMBC.
“Shrinking the balance sheet without reducing reserve demand would cause significant disruption in funding markets,” Abate wrote, presenting a challenge for a Fed that historically has “little tolerance” for volatility in the plumbing of the financial system.
Read the original article on Investopedia