Market Views: What we learnt about the new Kevin Warsh-era Fed

A new sheriff is in town at the Federal Reserve. Whilst past changes of chair have been a baton-passing moment, Kevin Warsh is ushering in nothing short of wholesale regime change at the Fed. Some things have changed immediately - like how the Fed communicates with markets; other things, such as trimming the balance sheet or changing how officials approach their inflation target, will take longer but be no less noteworthy.

So, what have we learnt from his first outing? 

Hawkish tilt

Far from the Trump-friendly dovish pivot that some had anticipated, the Federal Open Market Committee (FOMC) took a notably hawkish turn. This is largely about the economic data – inflation has turned higher and the labour market is more robust than thought. Fed officials raised their outlook for inflation and lowered it for unemployment this year, and correspondingly raised their forecast for where the fed funds rate should be by the end of the year. Cuts are off the table and markets are pricing in hike by September. "It's all right. Whatever," responded Trump.

Nine of the 18 officials who submitted estimates (Warsh refrained) expect higher rates by the end of 2026 – a big shift from March’s projection when no one baked in a hike and a significant shift from the last meeting. The median dot for the fed funds rate by the end of the year rose to 3.8% from 3.4%.

On top of the more hawkish outlook from the SEP, the tone from Warsh was unambiguously inflation-busting. He said: “Persistently high prices are a burden for the American people. But the recent past need not be prologue” and “Members of the FOMC are unambiguous and unanimous: this committee will deliver price stability”. The statement said the Fed "will deliver price stability" and made no reference to the other side of its dual mandate.

The combination of the more hawkish dot plot and Warsh’s repeated stress on delivering price stability pointed to the direction of travel being towards a hike.

And a lack of any forward guidance left the market to fill in the gaps – the only natural response was to price in a higher chance of a hike and bond yields at the front end couldn’t do anything but rise. 

So long, forward guidance

That hawkish signal was about all we got from Warsh. Communications from the Fed are clearly going to be less fulsome. Warsh cut the statement right down to just over 100 words “It’s a bit shorter, a bit simpler, and it dispenses with some older language,” he said afterwards. 

And forward guidance is over. The Fed not only dropped the so-called easing bias from its statement but Warsh also seems to have dispensed with any kind of forward signalling. “I don’t believe in forward guidance,” Warsh said during his Senate confirmation hearing in May. “I don’t believe that I should be previewing for you what a future decision might be.”

So is a rate hike likely in the coming months, asked one reporter. “I can’t give you any . . . guidance about what we’re going to do next,” the new Fed chair said. “The good news is we’ll be meeting in six weeks.” I guess the lack of forward guidance is a form of guide in itself. This implies a July hike is on the table and aligns with my previous stated views that the market was well behind the curve on the timing of rate hikes. The market won't be guided by the Fed anymore - that does not mean the Fed won't do anything.

The dot plot remains for now but could be dispensed with in the future on the outcome of a series of task forces that Warsh announced would be established, the first of which will "propose some well-considered changes, including to the SEP".

Regime change

Warsh is not promising more of the same – this is a reforming Fed chair. To that end he is appointing a task force in each of five areas that are central to the conduct of monetary policy: communications, balance sheet policy, use and reliance on existing data sources, productivity and jobs, and lastly inflation frameworks.

Indeed, there was a clear attempt to signal a break with the past in terms of hitting the 2% inflation target. “The commitment to deliver is strong, unanimous, and unambiguous, and that’s I think an important message we’ve missed for five years, and we’re going to fix that,” Warsh said in the press conference.

These changes buy some time and allow the Fed chair to avoid some uncomfortable decisions, potentially. “I’ve said for years inflation is a choice,” Warsh said. “You bet it is. By not submitting a dot himself he’s not revealing what his choice is.

Balance sheet

Warsh has been clear in the past that he favours using interest rates as the primary tool for monetary policy, and has indicated a desire to pare the Fed’s balance sheet, which has ballooned to more than $6.7 trillion. In the statement the FOMC “reaffirmed its policy of maintaining ample reserves in the banking system”. This told markets that balance sheet reduction won’t happen right away. 

But Warsh is not backing off. The task force on balance sheet policy “will review the benefits and risks of the current ample reserves regime, and the composition of the Fed’s balance sheet”. Importantly, they will “assess alternative frameworks for the conduct and operation of monetary policy”, which could see the Fed significantly trim down its balance sheet to levels not seen since before he financial crisis. 

This may be going too far even for Warsh and it could cause severe market stress akin to the 2013 Bernanke ‘taper tantrum', albeit the last time the Fed did QT the market barely noticed - like "watching paint dry" in the words of then chair Janet Yellen. I’d expect the Fed to find the right mechanisms for reducing the balance sheet without causing a taper tantrum, such as giving large banks more flexibility outside of reserve holdings and shifting issuance towards short-dated maturities.

Economic data

Economic data relied upon by the Fed – and by extension by market participants – is going to change. “Most of the data that central bankers and other government officials in the United States consume come with old-fashioned survey methods,” Warsh said, adding that he prefers private sector data compilers who use more real-time inputs and don’t rely on old-fashioned surveys.

Inflation targets

Warsh has been critical of the Fed’s shift in 2020 to flexible average inflation targeting, which allows for temporary overshoots above the 2% target. Warsh favours a stricter adherence to the 2% goal, but he talked in the press conference about his focus being on the number to the left of the decimal point – so as long as core PCE has a two handle he’d be happy. The SEP projects core PCE at 3.3% by the end of the year, up from a forecast of 2.7% in March. The core PCE index has had a three handle since December. ‘So why didn’t you hike today?’, asked Claire Jones at the FT... the new non-communicative Fed chair couldn’t say why because he had no forward guidance to lean on.

Warsh has previously urged the central bank to look at alternatives to the standard gauges of inflation, such as the PCE and CPI indices. Warsh wants the Fed to pay attention to measures of inflation that strip out the noise from extreme month-to-month movements. Several indicators exist but the most widely cited is the Dallas Fed’s trimmed mean, which was running at 2.3% in April vs 3.3% for the core PCE, the Fed’s current preferred gauge. The Dallas Fed trims more off the top than the bottom of prices, which means it was late to show up the 2021 surge in inflation. The implication is that Warsh may prefer to sit out periods of higher inflation – but it’s unclear whether this will impact policy immediately and we know that any changes to the way the Fed views inflation will not come overnight. There is a big question for the market here - is the hawkish signal from the SEP and inflation chest-thumping material? Or does the Fed simply adopt a new set of rules and data points that allow it to stay looser and potentially cut. The signalling is somewhat messy.

More volatility

The lack of guidance and the lack of any details about how the Fed may look at inflation and new sets of economic in the data means we are still figuring out what the new Warsh-era Fed will look like. Whilst I've tried to outline some thoughts here it remains somewhat unclear how it will all look in the end and what this means for financial markets. In the short term at least this could mean volatility around Fed events increases particularly for the front end. But improved inflation credibility will dampen vol at the long end and support the 30yr.