Quick View: The Fed wants 2%; the markets want a plan

The July Federal Open Market Committee (FOMC) meeting will likely be remembered less for the decision itself and more for the market’s reaction to Chairman Kevin Warsh’s explanation of it.

On paper, the outcome was straightforwardly hawkish: The Fed left rates unchanged at 3.50%-3.75%, retained language describing growth as solid and inflation as elevated, and delivered a notable 9-3 vote, with Beth Hammack, Neel Kashkari, and Lorie Logan dissenting in favor of an immediate 25 basis point (bp) hike. That alone represented the strongest hawkish signal embedded in a split vote in a decade.

Yet markets ultimately looked through the hawkish optics and focused on something else: the lack of clarity around how, when, and under what conditions the Fed intends to return inflation to its 2.0% target.

Throughout the press conference, Warsh repeatedly emphasized that inflation has remained above target for more than five years and reiterated his commitment to a hard 2.0% inflation objective. He stressed that there is “no soft inflation target” and repeatedly argued that the Fed would deliver price stability.

The problem was that investors were left asking the same question by the end of the press conference that they were asking at the beginning:

“If inflation remains too high, why didn’t the Fed hike today?”

Warsh’s answer centered on the significant tightening that had already occurred through market rates. Real and nominal Treasury yields have risen materially since June, and his argument was effectively that financial conditions had tightened even without an increase in the policy rate.

Intellectually, that is a defensible position: Markets often do some of the Fed’s work. But communication matters. Rather than providing a clear framework for future policy decisions, Warsh repeatedly circled back to themes such as market signals, uncertainty, task forces, and the need to answer the “big questions” facing the economy. What he did not provide was a convincing explanation of what additional evidence is required before the committee acts.

As a result, markets appeared to conclude that although the Fed remains committed to its destination, its roadmap has become less clear. That stance was reflected in the market’s price action during and after the press conference: The front end of the U.S. Treasuries curve rallied as investors removed the residual probability of a July hike and substantially reduced September tightening expectations.

At the same time, the long end sold off sharply, producing a material steepening in the curve. The difference between 10-year and 2-year yields steepened by around 11 bps, while the 30-year/2-year curve widened roughly 17 bps. Additionally, breakeven inflation rates derived from Treasuries moved higher across the curve. Particularly notable was the roughly 6 bps increase in 5-year inflation expectations – essentially a gauge of expected inflation between 2031 and 2036 and one of the market’s most closely watched measures of the Fed’s long-run inflation credibility.

Mixed messages

The discord between Warsh’s hawkish rhetoric and the Fed’s dovish interpretation is difficult to ignore. Markets are effectively saying two things simultaneously:

1. The Fed is less likely to tighten in the near term than previously thought.
2. The path back to 2% inflation is less certain than it appeared before the press conference.

We would stop short of saying Chairman Warsh has already lost inflation credibility. It’s only his second meeting as Chair, and he perhaps deserves a mulligan. Furthermore, his repeated commitment to returning inflation to target was arguably the strongest part of the entire event. However, he may have dented the Fed’s policy credibility.

While markets appear willing to believe his destination, they seem to be less certain about his plan for getting there. In that sense, this meeting evolved from a hawkish hold into something more complicated: A Fed that remains deeply concerned about inflation but one that is increasingly asking markets to trust its commitment, without yet providing a sufficiently detailed framework for future action.

The key question heading into September is no longer whether the Fed wants 2% inflation – it clearly does. The question is whether policymakers are relying too heavily on tighter market rates doing the work for them and hoping that yet-to-be-determined task-force conclusions will assuage investors’ concerns when inflation remains above target today.

For now, the market’s verdict is clear: strong commitment, unclear roadmap. While there are many variables, we can expect volatility on longer-dated Treasuries until the market gets more confident that the Fed indeed has a framework that can lead to long-term price stability.

IMPORTANT INFORMATION

Fixed income securities are subject to interest rate, inflation, credit and default risk.  The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa.  The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.