Warsh’s words put markets at ease, but volatility remains

• Key insight: Traders of bonds and futures contracts are favoring a rate hike after the Federal Reserve chair’s speech in Jackson Hole, Wyoming last week. The remarks appear to have repaired the central bank’s credibility for the time being.
• Expert quote: “Markets appear to have taken these remarks as his intended signal that a discussion about a policy rate hike is clearly on the table for the September meeting.” — Former Federal Reserve Vice Chair Richard Clarida
• Forward Look: Economists and analysts are split about whether the hawkish rhetoric will actually result in tighter monetary policy. This week’s jobs report and next week’s inflation reading will likely shape the Federal Open Market Committee’s thinking.

NEW YORK — Federal Reserve Chair Kevin Warsh did not mince words in his latest economic assessment: inflation is too high and it’s up to the Fed to fix it.

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In his keynote speech at the Federal Reserve Bank of Kansas City’s Jackson Hole Symposium last week, Warsh also said the labor market is solid and monetary policy is not restrictive. Bond traders and policy watchers took the remarks as a sign that interest rates will soon rise.

“It means that the default expectation is a rate increase, not a default for continued pause,” wrote Peter Conti-Brown, a financial historian and Wharton professor, in his weekly newsletter on Monday. “And it means that the probability of a coming confrontation with President Trump just increased.”

The much-anticipated speech seems to have mended the Fed’s much-maligned credibility under Warsh’s leadership. But some analysts were quick to note that confidence in the institution remains fragile.

“We were encouraged by Warsh’s speech,” wrote a Bank of America Global Research team led by U.S. economist Aditya Bhave. “But talk is cheap.”

Yields on two-year Treasuries — the instruments tied closest to the federal funds rate —  jumped more than 13 basis points after the speech, matching their highest level of the year as traders brace for a hike. Meanwhile, 30-year bonds — which recently hit their highest yields since the global financial crisis amid mounting concerns about inflation, war and soaring government debt levels — also appeared to settle after the remarks. The result was a slightly flatter yield curve, indicating a less volatile outlook among rate-setters.

Long rates shot up again on Monday following an exchange of missile fire between the U.S. and Iran over the weekend. Two-year yields also fell to start the week, but remained above their pre-speech levels.

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The impact of Warsh’s remarks were clearest in the federal funds futures market, where the odds of a September rate hike went from slightly more than 35% before the speech to 57% after. By Monday afternoon, roughly two-thirds of contracts had priced in a quarter-point increase. 

“Markets appear to have taken these remarks as his intended signal that a discussion about a policy rate hike is clearly on the table for the September meeting,” wrote former Fed vice chair Richard Clarida, now a global economic advisor for the investment firm PIMCO.

In particular, Warsh’s granular explanation of inflation concerns — noting that 54% of the 199 goods and services in the personal consumption expenditures index rose by more than 3% during the past year — seems to have resonated with economists and odds-makers.

‘Excessive reaction’

In an analyst note, Ernst & Young chief economist Gregory Daco said Warsh was “much more direct than any time over the past three months” in describing his level of concern about prices.

“First, he provided a clear, fact-based and nuanced assessment of the US economy, employment and inflation,” Daco wrote. “Second, he reaffirmed PCE inflation as the gauge for the Fed’s 2% target and the fed funds rate as the main policy tool. Third, he suggested a reaction function indicating readiness to tighten should inflation fail to move sufficiently rapidly toward the 2% target.”

Yet, despite the speech’s hawkish rhetoric, Daco believes markets are overestimating the likelihood of a rate hike in two weeks and reading too much into a speech that largely rehashes points raised during last month’s Federal Open Market Committee meeting.

“In our opinion, these odds are too high and reflect an excessive reaction to Warsh simply stating the obvious view that was reflected in the July FOMC minutes,” he wrote. “These reflected a low bar for rate hikes, with ‘many’ participants assessing that additional policy tightening would likely be necessary if inflation did not decline.”

He noted that the “many” participants likely consisted of the three committee members who voted for a rate hike last month —- Lorie Logan, Neel Kashkari and Beth Hammack, presidents of the Federal Reserve Banks of Dallas, Minneapolis and Cleveland, respectively — as well as non-voting reserve bank presidents Jeffrey Schmid of Kansas City and Alberto Musalem of St. Louis. At least two other FOMC members would need to join the dissenters for a rate hike to pass. While Fed Gov. Lisa Cook and Philadelphia Fed President Anna Paulson have said they would be open to raising rates if inflation persists, neither has suggested that such a move is imminent.

Bill Adams, chief U.S. economist for Fifth Third Commercial Bank, also said that Warsh’s speech contained “no new information,” reflecting “the same message as in the FOMC’s last two monetary policy statements.”

Adams said the FOMC decision on September 16 will depend on two data releases from the Bureau of Labor Statistics: the jobs report this Friday and the consumer price index inflation report on Friday, September 11. With early forecasts calling for another weak employment reading, Adams said the path to a rate hike is anything but clear. 

“For the Fed, Warsh’s speech confirms that a hike is possible at the next FOMC meeting in late September,” he wrote in a note. “But the bar to a hike will probably look higher after next Friday’s release of the August jobs report, since payrolls likely fell for a second month running.”

So while many traders expect a higher federal funds rate in September, some firms say persistent uncertainty is likely to keep the Fed’s benchmark rate unchanged heading into 2027.

“We continue to project the FOMC will hold the funds rate constant not only in September but through year-end,” wrote Larry Meyer, former Fed governor and chair of Monetary Policy Analytics. “This was already a fairly close call, and Warsh’s change of tone … which suggests he’s feeling some pressure from the reaction to his July presser — reinforces this.”